Where the investor has bought a stock which has subsequently fallen in price, the stock repair strategy may enable the investor to breakeven without the stock recovering to the purchase price. The strategy consists of a stockholding combined with a ratio call spread.
|When to use the stock repair strategy|
|Market outlook||mildly bullish|
|Volatility outlook||steady to increasing|
|The stock repair strategy|
|Construction||long stock, long call at X, short 2 calls at Y|
|Point of entry||market around X|
|Breakeven at expiry||around Y (depending on net cost/credit of options used)|
|Maximum profit at expiry||N/A|
|Maximum loss at expiry||net cost of options (if any), downside risk of stock|
|Time decay||market around X - hurts
market around Y - helps
|Margins to be paid?||no (assuming underlying stock lodged as collateral)|
Profits and losses
The stock repair strategy is designed to allow investors to break-even more quickly on a losing stock position. It does not involve investing more cash or increasing the risk of the position.
The strategy combines a losing stock position with a ratio call spread where twice as many calls are sold as are bought. Unlike the ratio call spread the investor is not exposed to unlimited losses on any of the written calls. The written call options are covered either by the long stock position or by the bought call. Ideally the spread is opened at no cost, or for a credit, with the premium received from the calls written at the higher strike price paying for the call bought at the lower strike price.
If the stock at expiry is above the strike price of the sold calls the stock is sold at this level. The remaining option position is a bull call spread that achieves its maximum profit at this same price. Profits from the bull call spread and the partial recovery in the stock allow the investor to break-even at a lower price than if the investor had simply continued to hold the stock.
If the share price at expiry is below the strike price of the sold options, these options will expire worthless, and the investor has only to close out the bought call to recover any intrinsic value.
If the stock price is above the strike price of the sold calls, the investor will need to close out one or both of the written legs. The investor may allow one of the calls to be exercised if they wish to exit their stock position. The bought call will also need to be closed out to recover intrinsic value.
Points to remember
- This strategy is suitable if your investment goal is to break-even and sell the stock.
- The strategy benefits from a small upward movement in the market. It should not be used if a strong upward movement is expected.
- If the stock continues to fall, the strategy does nothing to alleviate further losses on the stock.
In June, you buy 100 shares in ABC Limited for $5.00. Over the following two months, the stock falls to $4.00. You believe the stock has been oversold, but are not confident the stock price will recover to $5.00. If the stock was to make a moderate recovery, you would be happy to exit at breakeven. You enter the following strategy:
Buy 1 October $4.00 call @ 30 cents
Sell 2 October $4.50 calls @ 15 cents
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