Suppose we bought a good stock only to see it undergo a significant pullback in price. We still like the stock and feel that it will recover at least some of the ground that it lost.
There is a low-cost option strategy that can help you get back to a break-even status when the stock suddenly regains only part of its value.
The same strategy can also be used to greatly hance your profit in a stock for essentially no additional expense beyond the original cost of the stock.
This strategy is called the Stock Repair Strategy. The great appeal is that it involves no additional risk since it can be applied for little or no additional expense.
The Prerequisites
For this strategy to work, it is necessary for your fallen stock to make at least a partial recovery. If the stock price remains unchanged or continues to fall, this strategy offers no help.
The Plan
Buy 1 at-the-money call for each 100 shares of stock that you own.
Sell 2 out-of-the-money calls with the same expiration date to fund the purchase of your call.
Choose an expiration month for the options that is far enough out in time for the price of your stock to recover back to the strike price of the short calls.
This will produce a strategy of a covered call (long 100 shares + 1 short Jun 30 call) and a bull call spread (long 1 Jun 25 call + short 1 Jun 30 call).
How It Works
By buying a ratio spread of 1:2 of call options, you are bullish on the stock up till the expiration date.
Example 1
Suppose you bought 100 shares in December when it was $35. Initial the price went up, but in early March it slid to $23. You still like the stock and feel there is some hope for a recovery, though getting back to break-even at $35 seems far away.
With the stock repair strategy, you can buy 1 Jun 25 call for $3.30 per share and sell 2 Jun 30 calls for $1.75.
This nets you a credit of ($1.75 x 2 – 3.30)=$0.20.
Payoff
If the share is above $30 at the Jun options expiration, the stock will be called away at $30 per share. That’s a $7 per share gain over it’s present price of $23. The bull call spread will be worth $5 per share. The total gain will be (7 + 5 + 0.20)=$12.20 per share, equivalent to a stock price of (23 + 12.20)=$35.20.
Thus you will have reached slightly better than break-even, although the stock is still as much as $5 below your original purchase price.
Example 2
Suppose you bought 100 shares in Dec when it was $19.50. In early March the stock is down 15 percent to $16.50. If the stock can recover just 6 percent from its current level within 10 weeks, the stock repair strategy can help.
You can buy 1 May 15 call for $2.40 per share and sell 2 May 17.50 for $1.10 per share.
This requires you to pay ($1.10 x 2 – $2.40) = $0.20 up front.
Payoff
It costs $0.20 per share to hold a covered call + bull call spread.
If the stock is up 6 percent from its current value to $17.50 at the May options expiration, you will be slightly better than break-even. The stock will be called away at $17.50 per share for a $1 per share gain over its present price of $16.50. The bull call spread will be worth $2.50 per share.
Since the extra cost of the strategy is $0.20 per share, the net gain is (1.00 + 2.5 – 0.20) = $3.30, which is equivalent to a stock price of (16.50 + 3.30) = $19.80.
This is slightly better than break-even with the stock covering less than half of its loss.
Comment
In the second example, an upfront debit is required due to the shorter time expiration.
The first example was done for a small credit.
The longer the expiration, the more likely a credit will be generated.