Dan Passarelli outlines a useful strategy to combat falling stock losses.

The Stock Repair Strategy

After the beating most stocks took last fall and winter, a lot stocks seem to be staging their comebacks in this summer’s rally. But as experienced investors know, the market can always go lower—sometimes fast and furiously. Today’s post highlights what I call the stock repair strategy, a tool using options that can really come in handy if your stock goes south.

What is it?

The stock repair strategy involves only calls and can be implemented when you think a stock will retrace part of a recent drop in share price within a short period of time (2-3 months).

In my experience, the stock repair strategy works best after a decline of 20 – 25%. The goal is to “double up” on potential upside gains with little or no cost if the security retraces about half of its loss by the option’s expiration. Here’s how it works:

Once your stock has lost 20 - 25% of the original purchase price, and you’re anticipating a 50 percent retracement, you’d buy 1 close-to-the-money call and sell 2 out-of-the-money calls. The short calls’ strike price should correspond to the projected price point of the retracement. Both option series are in the same expiration month, which corresponds to the projected time horizon of the rally you expect.

The “one-by-two” call spread is ideally established “cash-neutral”, meaning with no debit or credit. (This is not always possible – more on this below).

What are you trying to achieve?

There are three benefits the stock repair strategy trader hopes to gain:

1. You want to add as little extra downside risk to the position as you can. This is not to say you can’t lose money – far from it. You still hold the original shares, so if the stock continues lower, your losses will continue to add up. This strategy is only practical when traders feel the stock has “bottomed out” and is poised to reverse.

2. You project a retracement of ~50% of the decline in stock price. A small gain may be only marginally helpful. A large increase will help but have limited effect.

3. You’re willing to forego further upside appreciation over and above original investment. The goal here is to get back to even and be done with the trade.


Stock repair strategy in action – a theoretical example

Imagine you’re holding 100 shares of XYZ stock, bought at $80. After a month of falling prices, XYZ trades down to $60 a share. You believe the stock will rebound, but not all the way back to his original purchase price of $80. That is, you think there’s a reasonable chance for the stock to retrace half of its loss (to about $70 a share) over the next 2 months.

Your goal is to make back your entire loss of $20 - without substantially increasing your downside risk by any more than the risk you already have as a stock holder. You’d start by looking at options with an expiration corresponding to your 2-month outlook, in this case the November series. Here’s what you might select:

Bought 1 Sep 60 call at 6
Sold 2 Sep 70 call at 3 (x2)
Net debit or credit: 0

By combining these options with the 100 shares already owned, you’d create a new position that gives double exposure between $60 and $70 to capture gains faster if your forecast is right. The image below shows how the position would function if held until expiration:
 


If the stock rises to $70 as expected, you’d make $20, which happens to equal what the lost when the stock fell from $80 to $60. (Of course, these gains would be offset by commissions for the calls you bought and sold, in this case $11.85.) In other words, you were able to regain more or less the entire loss in a retracement of just half of the decline. Pretty sharp, eh?

Let’s break these down, leg by leg. With the stock above 60 at expiration, the 60-strike call could be exercised to become a long-stock position of 100 shares. That means you’d become long 200 shares when the stock is between $60 and $70 at expiration. Above $70, however, the two short 70-strike calls would most likely be assigned, resulting in the 200 shares owned being sold at $70. That’s why I said earlier that a retracement greater than 50% wouldn’t help you much – you can see here that you’d forfeit further upside gains above and beyond $20.

What if you’re wrong, though? Instead of rising in price, say the stock continues lower and is trading below $60 a share at expiration. In this event, all the options in the spread expire and the trader is left with the original 100 shares. You’d be out the cost of the initial options trade, and the further the stock declines, the more you could lose. But the option trade won’t contribute to additional losses past this point. Only the original shares are at risk.

Benefits and Limitations of the Stock Repair Strategy

The stock repair strategy is very specific in what it can (and can’t) accomplish. The investor considering this option strategy must be expecting a partial retracement and be willing to endure more losses if the underlying security continues to decline. Furthermore, you must accept limiting profit potential above the short strike if the stock moves higher than expected.

If all of the above is true, you may find this tool comes in handy the next time one of your stocks starts to slide.


Regards,
Dan Passarelli
Founder, Markettaker Mentoring
TradeKing All-Star Commentator

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.

In reading content in the Trader Network, you may gain ideas about when, where, and how to invest your money. Although you may discover new ideas or rationale that may be compelling, you must ultimately decide whether or not to put your own money at risk. Consider the following when making an investment decision: your financial and tax situation, your risk profile, and transaction costs.

Dan Passarelli / Markettaker maintains a cross-marketing relationship with TradeKing.