No matter how much research you do, sometimes things just don’t work out as planned.
The sector you thought was about to run hot suddenly fizzles.
Or the stock you bought in anticipation of big profits rolls over and tanks instead.
It can happen if you’re new to the markets… or even if you’ve been around the markets for 40 years like me.
Of course, as painful as it is, sometimes it’s best to cut your losses and move on to your next trade. That’s especially true if the reasons you bought the stock no longer exist.
But things are not always clear-cut…
What do you do if you still believe the stock could bounce back?
That’s where an options strategy comes into play…
It can potentially recoup your losses – even if the stock doesn’t recover back to your entry price.
So let’s see how you do it…
Lowering the Breakeven
The options play I’m talking about today is often called a “stock repair” strategy.
To understand the strategy, let’s consider an example where you buy 100 shares of a stock at $200. But after buying those shares, they tumble down to $100.
Now, if the reasons you had for buying those shares no longer exist, the best thing to do is to cut your losses.
But if you believe the stock has the potential to recover, you have choices…
You could hold on and hope the stock gets back up to $200. But that could take way longer than you hope – if it happens at all.
That’s a lot of lost ground to make up. So consider the strategy we’re looking at today…
In this scenario, you decide to keep your 100 shares.
Then you also buy one call option with a strike price of $100. That’s right around the current stock price.
Buying that call option gives you the right to buy 100 shares at $100 per share right up until the option expires.
If you choose to exercise that option, you’ll own 200 shares and lower your average entry price to $150.
So the stock only has to get back to $150 for you to recoup your money now.
But for the moment, you’ll just hold the call option. And it costs you something to buy that call option.
That’s where the second leg of this strategy comes into the picture…
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Recouping Losses
The next step is to sell two call option contracts at a $150 strike price.
That way, you receive enough premium to cover the cost of buying the call option contract… and even potentially bank a credit.
If the stock rises to $150 (or higher), the option buyer will likely exercise the options, and you’ll be out of the trade at net even.
So to recap…
By following this “stock repair” strategy, you dropped your breakeven on the shares from $200 down to $150.
And you also likely put a credit in your account from selling the two call options.
It’s kind of like a free hit…
You’re reducing your breakeven without committing any additional capital.
If the stock stays around the current level (or falls), you’re no worse off than if you had just held on to your original 100 shares.
But this gives you a shot to recover your losses.
Risks Versus Obligations
As with all option strategies, you need to understand the risks and obligations.
Using our example, the bought $100 call option gives you the right to buy 100 shares at $100 per share right up until expiry.
But the two sold call options require you to hand over the shares at $150 if the buyer exercises the $150 call options – even if the shares are trading much higher.
And because options have a finite life, the clock is always counting down to the option’s expiration. So you have to get the move you’re looking for in the right time frame.
And to be clear, this strategy offers no protection if the stock price continues to slide.
So you’ll only want to use it when you still believe in your reasons for investing in the stock in the first place.
In that instance, it can be a really useful strategy when you think a stock could recover.
And ultimately, it’s a great strategy to keep in your options trader toolbox…
Regards,
Larry Benedict
Editor, Trading With Larry Benedict