Chapter 3: Stock Repair Strategy

This is a great strategy to employ if you have already purchased shares of stock that are optionable and are stuck in a situation where you are watching its value decline with no clear recourse to rectify the situation. If the stock you purchased was non-actionable, then all you would be able to do is hold onto it in hopes that things turn around or double down in hopes of turning a profit at a lower breakeven point. Luckily, with optionable stocks, you also have a third alternative.

The stock repair strategy is ideal for those who are looking to break even on a stock that they purchased at a point significantly higher than where the current market price stands and are looking to break even. It is important to keep in mind that you will need to be willing to forfeit any profit potential, even at the reduced breakeven point. This is also a good choice if you can’t or are unwilling to commit any additional funds to the position in question.

The repair strategy is useful in helping you break even, especially if you are already in losing position. To utilize it you are going to want to sell 2 call options at a strike price above the current stock price and purchase 1 call option at the current price for every 100 shares of the failing stock you own. All of the options should have the same period of expiration. These sales and purchases are constructed in such a way that the additional funds you have to invest are slim to none.

Stock repair example

As an example, consider that you started out with 100 shares of a stock that you purchased for $50 a piece only to watch them fall to the current price of $40 each. You are unwilling to invest anything else into this stock and are afraid to take any more downside risk. Once you are ready simply to break even, then it is time to initiate the stock repair strategy.

To begin, you would want to purchase a single 60-day call option on the stock at the $40 price point for $3 while also selling 2 60-day call options at $1.50. It is important to keep in mind that the spread won’t cost you any credits or debits. This is because the cost of the calls you purchased at the rate of $3 per 100 shares for a total of $300, will be completely offset by the premium that is generated from the sale of the written calls at the rate of $1.50x2x100 for a total of $300.

The purchase of the $40 call will provide you with the opportunity to purchase another 100 shares at the $40 price point while the 2 $45 calls will mean that you have to sell 200 shares at $45 if you are assigned. While you currently only have 100 shares, you could exercise the $40 long call to generate the required extra shares and make $5 per share at a relative profit of $500 which would cover the assignment.

There are several different likely scenarios that will come into play at the point the options expire. First, the underlying stock could continue to decrease and close around $35. It could remain at the current rate and close at $40. It could also regain some lost ground and close at $45. The best-case scenario is that it rises back to the price purchase price of $50 per share.

If the underlying stock continues to decrease in value and ends at $35, then all 3 of the calls will expire worthlessly out of the money. As the option position didn’t cost anything to execute you wouldn’t be out any more money that you would if you had simply held the stock and waited to see what would happen. As such the strategy has no negative or positive effect. This illustrates a salient point that this strategy will do nothing to protect you from additional losses to the underlying stocks. As such, if you expect the price to continue to fall after the initial decrease then a different strategy is recommended.

If the underlying stock remains at the $40 price point until the options expire then all of the call options will expire without any value. Once again, nothing extra was lost in the construction of the strategy, and you would be in the same position from where you started. If nothing else has changed, setting up a new round of calls and attempting the strategy again is recommended.

If the underlying stock rises in value to the point that is only $5 less than when you first purchased it then the short calls at the $45 price point will expire without value. However, the long call can then be sold at a $5 profit per share as the strategy was implemented with no additional costs. This, in turn, will reduce the amount lost on the original price decline to just $5 per share instead of $10 per share. After the $5 profit is factored in you will actually break even via this occurrence. Essentially what is managed in this scenario is that you have lowered the initial breakeven point from $50 to $45, breaking even without requiring the underlying stock to recover past the original purchase price.

If the price of the underlying stock rallies back to the original price of $50 per share then the long shares will be in a breakeven position, the long call at $40 will be worth $10, and the short calls will now be worth -$5 each. The net result of this will be that you still breakeven overall with the gains and the losses canceling one another out. Even if the price continues to rise past the $50 point, you will still be unable to make a profit as the mixture of calls will continue to cancel one another out.

As such, if you feel as though there is a chance that the underlying stock is going to rally, then in order to mitigate the constant breakeven status you would want to liquidate the new positions you created as quickly as possible. You could sell the $40 call for the intrinsic value it holds of $10 and purchase the $45 calls for their intrinsic value of $5 and close out the strategy for just the added commission costs. With this done you would then be left free and clear on your 100 shares and once again able to profit from prices increases past the original $50.

Determine the right strike price

One of the most important considerations that come along with establishing a repair strategy that can be as effective as possible is determining the right option to purchase and the correct one to sell. The $5 price chosen in the above example took half of the unrealized loss into account. As such, if you started with an underlying stock priced at $100 and were currently sitting with shares at $90 then you would want to purchase calls at $90 and sell calls at $100 as $10 is half the unrealized loss. If you plan on purchasing at the money options, then you will want to sell out of the money options that are halfway between the current price of the underlying stock and the price you originally paid.

Furthermore, it is important to keep in mind that the repair strategy will not work successfully for every stock that is currently trading below the purchase price. The strategy tends to be effective for stocks that are down up to 20 percent from their original purchase point as long as options are utilized with a range of between 60 and 90 days. However, it is ineffective if the underlying stock has already dropped as much as 40 or 50 percent. In these cases, the selling of a pair of out of the money calls will not make up the difference and generate a large enough premium to balance out the cost of the single at the money call.

Finally, it is important to keep in mind that the stock repair strategy can often be initiated for a small debit or credit. You may still want to consider it a viable strategy if you have to pay up to $.50 for initiating the position. If this is the case, then you will need to give up a small debit regardless of how high the underlying stock will ultimately increase in price. However, the effectiveness of the strategy may still outweigh these additional costs.

On the other hand, however, if the option position is established for a credit that is slightly above the break-even point then you might keep the credit. The final loss or profit scenarios use this strategy will then vary depending on the original price of the underlying stock when it was purchased, the price of the stock when the repair strategy was put into play, whether a debit or credit was required to establish the position and the strike prices chosen.