THE STOCK REPAIR STRATEGY
The Stock Repair Strategy
When traders find themselves in a losing trade position, they usually think they only have 3 options to deal with it:
1) Sell the position and take a loss...
2) Hold on and pray that it turns around...
3) 'Or, Double Down' on the position - which requires 'throwing good money after bad'.
However, there is another strategy called the 'Stock Repair Strategy' that can help 'fix' and 'repair' a trade simply by making an adjustment that can reduce the break even point in the position - WITHOUT taking on any additional risk.
What Exactly Is The Stock Repair Strategy?
The stock repair strategy is a long stock position combined with a call ratio spread.
The position consists of the long stock, the purchase of an at-the-money call and the sale of two out-of-the-money calls.
What Is The Stock Repair Strategy Attempting To Do?
The stock repair strategy is attempting to lower the breakeven level of a losing long stock position.
By lowering the breakeven level, the idea is that hopefully the investor is able to exit the entire position without losing any money overall.
How Is The Stock Repair Constructed?
The stock repair strategy is simply long stock with a call ratio spread added.
Let's take a look at an example:
Let's suppose that investor Bob has bought 100 shares of stock ABC at a price of $50 per share for a total investment of $7400 in November.
Unfortunately, Bob is not a very good stock picker and the stock begins trending lower after Bob bought it.
Before Bob knows it, the stock price has fallen to $40 per share.
At this level, Bob is down $1000 on his investment.
Bob decides to implement a stock repair strategy.
Bob does this by purchasing the December $40 call option for a premium of $200 and selling two of the December $45 call options for a combined $200.
The position has, therefore, been put on at even money meaning that neither a credit nor debit has been made.
Now let's look at some scenarios:
Let's suppose that the shares are trading at $45 per share at the December options expiration.
In this case, the two short $45 calls expire worthless while the long $40 call option has $500 of intrinsic value.
Bob can sell the $40 call for a $500 profit and in addition his stock has come back by $5.00 per share or $500.
Therefore, Bob has regained the $1000 he was down on the position and may now exit the position without having lost money.
Now, let's assume that shares of ABC rocketed higher after Bob put the repair strategy on and it's now trading at $60 per share at the December options expiration.
In this case, the $40 call option would have $2000 of intrinsic value.
The two $45 calls that Bob sold would have a combined $3000 of intrinsic value.
Bob, therefore, is down $1000 on the options position, however, Bob's long stock has come back by $2000.
If you take the gains in the long stock and subtract the option losses Bob has recovered $1000 - the original amount he was down.
In this case, regardless of how high the shares go - Bob would only breakeven.
Should the shares plummet further after a stock repair strategy is initiated, then the trader or investor is no worse off than if they did not use the repair strategy (as far as the options go.)
In this case, all options would simply expire worthless and Bob's losses would increase by however much the stock falls further.
Let's take a look at one more example, this time with visuals...
In this example, let's say that Bob opened a different position - this time purchasing 100 shares of stock XYZ when it was trading at $185.00 per share.
However, after purchasing the shares, the stock dropped in price, and is now currently trading around $177.00 - giving Bob a current loss in the position of around -$800.00 (see example below)...
And here below is a risk graph of the current losing position (see example below)...
So Bob decides to use the Stock Repair Strategy.
He goes to the option chain, finds the chain that is around 2 months out, and then finds the call option with a strike price that is closest to where the underlying stock is currently trading at - which is the 175 call option priced at 8.50 (see example below)...
Then Bob scans up through the option chain until he find a call option that is priced at roughly HALF the price the 175 call option that is priced at 8.50.
He finds that the 185 call option is priced at 4.10 which is roughly HALF of the cost of the 175 call option (see example below)...
Then Bob uses these options to create a call ratio spread - buying one 175 call option for 810.00 and sell two 185 call options for 4.10.
Here is how the call ratio spread looks by itself in risk graph form (see example below)...
Then, when combined with the already open stock position of 100 shares - the COMPLETE position now looks like this (see example below)...
By using the stock repair strategy, Bob has moved his breakeven level DOWN - so that the stock does not have to move as far up as it did before, in order for the position to reach break even - and even get into profit.
Before applying the stock repair strategy, the break even level on the trade was at the 185.00 trading level (see example below)...
However, by applying the stock repair strategy, Bob has moved the break even level down to the 180.00 trading level (see example below)...
What Are The Risks Associated With The Stock Repair Strategy?
While the stock repair strategy can be extremely useful, it is not entirely foolproof.
Holding on to a losing position may not be a good idea in the first place and the repair strategy will not always work in which case the investor may suffer further losses on the long stock position.
The stock repair strategy may be useful under certain circumstances if used correctly.
One must be willing, however, to endure a further drop in the stock price if they are going to try to repair it.
If one is willing to get out of a bad position at breakeven, the tool may at times help one do so.
It should not, however, take the place of proper risk control and common sense.