Wednesday, 8th September 2010

Stock Repair

Written by George Traganidas Topics: Articles, Options, Wealth Building

Fool.com
By Jeff Fischer
August 10, 2009

Who should use the stock repair strategy? Someone who is:

  • Down 15% to 25% on a stock and willing to forego profits to sell at breakeven.
  • Not interested in averaging down or holding for the long haul.
  • Using a margin-approved account and can write call options.

At some point, every investor gets stuck hanging onto a stock that has declined 20% or so and never seems to recover. This guide will teach you how to use options to exit laggard positions at breakeven. The “stock repair” option strategy not only recoups your initial investment, but frees up your cash for new, stronger buys.

But first, a reality check: Stock repair does not protect you from additional downside in the shares you already own — nor does it offer you a profit above your break-even price. The strategy can, however, lower your cost basis in your losing stock and allow you to exit the position at breakeven without introducing any additional risk.
Setting It Up

To set up a stock repair, for every 100 shares of a losing stock you (woefully) own:

1. Buy one call option at a strike price below the current share price.
2. Sell (write) two call options at a strike price above the current share price.
3. Use the same expiration date for the options you buy and sell.
4. Typically, use options that expire in 90 days or less.

These option trades result in minimal or no cash outlay for you because the call you buy is paid for by the two calls you sell. Plus, the strategy does not bring new risk to your stock — your options are neutral and covered: They largely cancel each other out, and the first call option you sell (or write) is covered by the 100 shares of stock you already own, while the second call you sell is covered by the new call you just bought. Got that? Let’s turn to an example to show how it works.

Repair That Dog!

Assume you purchased 100 shares of a stock at $40 per share, and it now trades at $30. You’re down 25%, lack hope for the stock’s recovery, and don’t want to hold your shares any longer. At the same time, you don’t believe there’s high risk left in the stock — otherwise, you’d simply sell. It seems your best move to get to breakeven is to initiate a stock repair strategy.

To start, you purchase a $30 call option for $2.50 that expires in 60 days. You then sell two $35 call options for $1.25 each. Your option trades have paid for themselves. Your positions look like this:

  • Original stock, bought at $40, is now $30
  • Buy one $30 call option costing $2.50
  • Sell two $35 call options for $2.50 total income

Here are your possible outcomes:

IF the $30 stock … THEN …
Declines or holds steady at $30 All the options expire, nothing changes (you just lost on commissions). You can try again.
Ticks up a few dollars — say, to $32.50 You make $2.50 per share on your $30 call option (because you bought it for $0 net cost) and by selling the call for the gain, you’ve effectively lowered your stock’s cost basis to $37.50. The calls you wrote expire. You can use the strategy again.
Recovers to $35 — bingo! Your $30 call is now worth $5 per share, all profit, so your cost basis in the stock is now $35. You can sell or close all positions and break even (commissions aside).
Soars to $40 No problem. You are breakeven on the stock, and your options cancel each other out. You can close everything and move on.
Catapults beyond $40 All of your positions still cancel each other out, and you can still sell your stock at breakeven. You’ve foregone a profit in the stock, though.

As you can see, the stock repair strategy has three possible results: (1) no change at all if the stock doesn’t move or declines; (2) a lower cost basis if the stock ticks up; or (3) a break-even sale if the stock cooperates even halfway.

But what if you set up a stock repair trade only to change your mind and turn bullish on your stock again? The situation is salvageable. Let’s say your stock returns to $40 on good news, and you wish to keep owning it. In that case, you can close all of your option trades at or near breakeven (they’ll largely cancel each other out) and continue to hold the stock.

Choosing Your Strike Prices

In general, this strategy works best when you’re down about 20% on a stock. You buy your lower-priced call options at a strike price that is about 20% below your stock’s start price (or, at about the current share price), and you write your two other call options at the midway point between the current share price and your stock’s start price, splitting the two. So, in another example, if you bought 100 shares of a stock at $50 that is now $40, to repair it, you’d buy one $40 call and write two $45 calls.

Bottom Line

When you’re down a reasonable amount on a lagging stock and simply want out at breakeven, setting up a stock repair strategy may help you meet your goal more quickly. The strategy does not increase or decrease your risk in owning the stock, but (unless you close the options early) it does limit your upside to your break-even price. You must be happy to just breakeven and confident the stock won’t fall sharply while you wait.

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