Introduction To Stock Repair Strategy
A trader with a long position will suffer a loss when the price of the underlying security goes down. There are a few ways to reduce the losses. Why would a trader or investor want to repair a trade? The first reason is that he wants to exit at a profit or reduce his losses. The second reason which is tied to the first is that he wants to perhaps accumulate a larger position at a lower cost for he knows that over the long term of perhaps 2 years, the price of the underlying security may appreciate tremendously. In this article, we discuss a few ways to repair the trade.
For one, a trader can average down by buying more shares at a lower price. In this way, the trader reduces the average purchase price of the share. This is a good strategy for long term investors who feel that the price of the stock is drastically undervalued.
Write Covered Calls & Earn Premium Over Time
One other way is to write a call against the long position of the underlying security, collecting premium over time which acts to reduce the average purchase price of the shares.
At times, the price of the stock stays depressed over long periods of time but it may be indeed undervalued. Perhaps, considering that the stock is undervalued and there is not catalyst over the short term, the investor may write monthly or periodic call options. When the options expire worthless, the investor of trader gets to keep the premium. This premium reduces the average price over time.
However, there is a setback to this strategy. Supposing that the option writer, in this case, the investor or the trader is forced to sell the shares, this has effectively limited the investor’s upside.
For example, the investor may have purchased 100 shares of HHH Corp at a price of $50 and writes a monthly call option at a strike price of $55 at a price of $50 premium. He gets to keep the premium of $50. But at some point, the price may rise and the trader may be forced to sell his shares under his obligation as a call writer, at a price of $55. Hence, he only earns a $5 per share profit plus any premiums collected to that point.
Writing covered calls is an income strategy and a repair strategy but it also limits the upside. However, the better investors know when to write and when not to. Perhaps, for the next 6 months, without a catalyst, the investor will write call options and thus get the earn the premium. But beyond that, he refrains from writing options so as to allow the upswing in stock price to take place, capturing a sizeable amount of profit from the markets in the form of capital appreciation.
Read : General Overview Of Covered Calls
Execute A Call Ratio Spread To Lower The Breakeven Point
Another way is to execute the stock repair strategy which involves a call ratio spread. This is done by buying one at the money call and selling 2 out of the money calls.
The stock repair strategy helps to reduce the breakeven price point and allows the trader to exit the trade without losing money. And this is done at no cost to the trader. The premiums collected from the writing of out of the money calls allows the trader to buy an at the money call to capture any upside price moves of the underlying security.
Advantage of using the stock repair strategy using a call ratio spread
The advantage of using the stock repair strategy is that it allows the trader to exit the trade without making a loss. Also, executing the stock repair strategy does not require any capital outlay.
Disadvantages of a stock repair strategy using a call ratio spread
While the trader can exit the trade without a loss, the trader stands no chance of ever making a profit. This is not for long term investors who project that the price of the underlying security will rise over time.
Executing a stock repair strategy with a call ratio spread
For every 100 shares of the underlying security owned, 1 at the money call is purchased and 2 out of the money calls is sold.
The price of ABC Corporation is trading at $40. Unexpectedly, the stock drops to $30. The investor wants to get out of the trade quickly and does not want to suffer a loss on the trade. He buys a December 30 call at $2 and shorts 2 out of the money December 35 calls at $1 each
Total cost of buying 1 ATM call and shorting 2 OTM calls is:
$200 – $100 – $100 = 0
The investor has not spent any money on the call ratio spread to repair the loss of value on the long stock positions.
When the price of ABC rises to $35 on expiration date of the options, the long call is now worth $5.
$5 – $2 = $3
$3 x 100 = $300
Therefore, $300 is made on the long call.
The 2 short call contracts expire worthless on expiration date. The trader gets to keep $200 on the short call contracts.
The stock loses a value of :
$40 – $35 = $5
$5 x 100 = $500
The stock loses a value of $500.
$300 + $200 = $500
$500 is the gain on option contracts.
$500(gain on options) – $500(loss on value of stocks) = 0 (no net gain)
Hence, the trader gets out of the entire trade by using a call ratio spread and just breaks even without a loss or profit.
Even if the stock of ABC trades at $100, no profit can be realised. The advantage to this though is that there is no additional downside risk to the trade.