Stock Repair

Who Should Consider Using the Stock Repair Strategy?


An investor who owns shares purchased at a price well above the current market price, and whose goal is to simply break-even on this position
An investor who is willing to give up any profit potential above the new, reduced break-even point
An investor who is unwilling to commit additional funds to the current losing stock position
The goal of the strategy is to reduce the investor's break-even price, without having to assume any additional downside risk.

Please note: This transaction must be done in a margin account.

Definition


An investor has bought shares in a non-optionable stock and has seen its value decline after purchase. He is now simply looking to break-even and has two choices: "hold and hope" or "double up."

The "hold and hope" strategy requires that the stock retraces its fall all the way back to the investor's purchase price, an event that may be a long time in the making. The "double up" strategy, i.e., purchasing additional shares at a now lower price, does lower the investor's break-even point, but it requires that additional funds be committed to the strategy. It also increases the downside risk of the position by the additional shares purchased. However, an investor who has an unrealized loss on an optionable stock has a third alternative: the repair strategy.

The repair strategy is built around an existing stock position, usually a stock that is now trading at a lower price than the investor's original cost. For every 100 shares held, 1 call option is purchased and 2 call options with a higher strike price are sold, with all options having the same expiration month. These purchases and sales are structured so that the investor's cash outlay is minimal or none.

How to Use the Repair Strategy


Please note: Commission, dividends, margins, taxes and other transaction charges have not been included in the following examples. However, these costs can have a significant effect on expected returns and should be considered. Because of the importance of tax considerations to all options transactions, the investor considering options should consult with his/her tax advisor as to how taxes affect the outcome of contemplated options transactions.

Example


An investor has purchased 100 shares of XYZ stock at $50 and seen the value of these shares fall to the current price of $40. He is not willing to invest more capital to this losing stock position, doesn't want any more downside risk than he already has, and is happy to just break even. He decides to establish a repair strategy.

This investor could purchase 1 60-day XYZ 40 call at $3.00 and simultaneously sell 2 60-day XYZ 45 calls at $1.50, a strategy that by itself could be referred to as a "ratio call spread" Note that in this case the spread costs the investor no debit (or credit). The cost of the purchased calls ($3.00 x 100 = $300) is fully offset by premium received from the sale of the written calls ($1.50 x 2 x 100 = $300).

The purchase of the 1 XYZ $40 call, gives the investor the right to purchase an additional 100 shares at a cost of $40 per share. The 2 written $45 calls means that the investor could be obligated to sell 200 shares of XYZ at $45 if assigned. Currently, the investor holds only 100 shares, but if needed the long $40 call could be exercised and another 100 shares purchased at $40 to cover the assignment.



Consider four possible scenarios at expiration:

  • XYZ falls and closes at $35
  • XYZ is unchanged and closes at $40
  • XYZ rises and closes at $45
  • XYZ rises and closes at $50
 
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