Now that we have talked about repairing a stock, we can discuss the actual process of doing so. Let’s say for this example that you invested 100 shares in a stock at $70 but that stock has fallen to $60.
- Buy a long call option with a strike price at the current value of your stock. You can buy a 60-day call on the stock with a strike price of $60 at a $3 premium.
- Sell two short call options with a strike price over the current value. Here you can sell two 60-day calls on the stock with a strike price of $65 with a $1.50 premium for each. Make sure the total value of the option you buy is identical to the combined total of the two call options you are writing. Keep the expiration date the same for those options.
- Review how the stock changes in value.
Possible Results
So, what will happen with your stock repair efforts? Let’s look at what would happen in this example based on five individual results.
- What if the stock falls in value? The long and short calls that you put in will expire if the stock falls even further in value. The stock in this example would end below the $60 strike price. As those two options fail to move forward, you will continue to be out-of-money at this point. If anything, the best strategy is just to sell off the stock and accept the loss as it is. Besides, there is a good chance that loss will only get worse if you keep the stock for too long. The only charges that you would have to pay are for commissions. You have the option to try working with a repair again, but even then it might be too late because the stock will have fallen to a much lower value than what you had at the beginning.
- What if the stock doesn’t change at all? You will not get anything going at all if the stock does not change in value. It would still be out of the money with those two strike prices because it has not moved. Remember, the strike prices for the sell and buy are $60 and $65. You need the stock value to stay high above the bottom value and over the top if possible.
- What if the stock makes a minimal gain? Let’s say that the stock moves up by a dollar and ends at $61. At this point, you will be in the money on your $60 call option, thus giving you $1 per share minus commissions. The two calls that you wanted to sell will have expired and will not be exercised. This helps you to recover some of your losses, not to mention the stock will have gone up a little. You can use the strategy again if you wish, but you would have to look at any trends on the market beforehand to see if they are favorable and could support any moves you make in the future. More importantly, you would have to see if the money you gained from the repair actually covers the losses you encountered. Selling the stock at this point might help if you do not see that the stock is actually going to move up any higher in value.
- The stock gets to a value above the two options you sold. For this example, the stock will be at $67. Your long call will be in the money as you buy the shares at $60 and sell them at $67 with a $7 per share profit. However, those two shorts will have to be paid off as well and you will sell your shares at $65 when you bought them at $67 - for a loss of $4 per share. In this case, you would have a profit of $3 per share. In this example, you would have broken even on your investment with the only costs involved being the charges associated with getting the options and trades managed.
- The stock gets back to the original purchase price. It would obviously be great if your stock got back to the $70 value at this point. Even then, the options that you made would make a huge impact. The long option would be worthwhile as you will make a $10 profit on that $60 long call. By working with the two shorts, you will have a $10 loss on those two moves. You might have broken even on the options, but the stock is still at the same value that you bought it while also out-of-money on all the extra charges and premiums associated with the trade. Remember, those $3 and $1.50 premiums will still go into effect on your options trade.
