Who Should Consider Using the Stock
Repair Strategy?
- An investor who owns shares purchased at a price well above
the current market price, and whose goal is to simply break-even
on this position
- An investor who is willing to give up any profit potential
above the new, reduced break-even point
- An investor who is unwilling to commit additional funds to
the current losing stock position
The goal of the strategy is to reduce the investor's
break-even price, without having to assume any additional downside
risk.
Please note: This transaction must be done in a margin account.
Definition
An investor has bought shares in a non-optionable stock and has seen
its value decline after purchase. He is now simply looking to
break-even and has two choices: "hold and hope" or "double up."
The "hold and hope" strategy requires that the stock retraces its
fall all the way back to the investor's purchase price, an event
that may be a long time in the making. The "double up" strategy,
i.e., purchasing additional shares at a now lower price, does lower
the investor's break-even point, but it requires that additional
funds be committed to the strategy. It also increases the downside
risk of the position by the additional shares purchased. However, an
investor who has an unrealized loss on an optionable stock
has a third alternative: the repair strategy.
The repair strategy is built around an existing stock position,
usually a stock that is now trading at a lower price than the
investor's original cost. For every 100 shares held, 1 call option
is purchased and 2 call options with a higher strike price are sold,
with all options having the same expiration month. These purchases
and sales are structured so that the investor's cash outlay is
minimal or none.
How to Use the Repair Strategy
Please note: Commission, dividends,
margins, taxes and other transaction charges have not been included in
the following examples. However, these costs can have a significant
effect on expected returns and should be considered. Because of the
importance of tax considerations to all options transactions, the
investor considering options should consult with his/her tax advisor as
to how taxes affect the outcome of contemplated options transactions.
Example
An investor has purchased 100 shares of XYZ stock at $50 and seen the
value of these shares fall to the current price of $40. He is not
willing to invest more capital to this losing stock position, doesn't
want any more downside risk than he already has, and is happy to just
break even. He decides to establish a repair strategy.
This investor could purchase 1 60-day XYZ 40 call at $3.00 and
simultaneously sell 2 60-day XYZ 45 calls at $1.50, a strategy that by
itself could be referred to as a "ratio call spread" Note that in this
case the spread costs the investor no debit (or credit). The cost of the
purchased calls ($3.00 x 100 = $300) is fully offset by premium received
from the sale of the written calls ($1.50 x 2 x 100 = $300).
The purchase of the 1 XYZ $40 call, gives the investor the right to
purchase an additional 100 shares at a cost of $40 per share. The 2
written $45 calls means that the investor could be obligated to sell 200
shares of XYZ at $45 if assigned. Currently, the investor holds only 100
shares, but if needed the long $40 call could be exercised and another
100 shares purchased at $40 to cover the assignment.
Consider four possible scenarios at expiration:
- XYZ falls and closes at $35
- XYZ is unchanged and closes at $40
- XYZ rises and closes at $45
- XYZ rises and closes at $50
XYZ falls to $35 at option expiration
If at expiration the price of XYZ has continued to
decline and closes at $35, both the long 40 call and the short 45 calls
will expire out-of-the-money and worthless. Since the investor initiated
the option position at no cost and all of these options have expired
with no value, the option strategy has had no impact on the overall
position. The investor has seen an additional $5 per share loss (or $15
from the original stock purchase price) accrue on the original shares,
the same as would have resulted had the shares simply been held on to
and the repair strategy not been used.
It should be noted that if the repair strategy is utilized, as the stock
continues to decline it will not protect the investor against any
further loss from the underlying stock position. If the investor is
expecting the price of XYZ to continue to fall, a strategy other than
the repair strategy might be considered.
XYZ is unchanged at $40 at option
expiration
If at expiration the price of XYZ is
unchanged over the price when the repair was established and closes
at $40, the situation is very similar to the one above. All of the
call options expire with no value, and the investor is left with the
shares originally purchased at $50 and the same $10 per share
unrealized loss. Once again the repair strategy has neither helped
the original stock position nor increased its risk.
XYZ rises to $45 at expiration
If XYZ has increased and closes at $45 at expiration,
the investor's short 45 calls will expire exactly at-the-money and with
no value. However, the investor's long calls will be in-the-money and
worth $5. If the long call is sold the investor will have a net $5
option profit, keeping in mind that the repair strategy was established
for no cost. On the long stock position, with XYZ at $45 the unrealized
loss on the shares originally purchased at $50 will be reduced to $5.
Taking this $5 stock loss and the $5 profit on the option position, the
investor breaks even on the overall position.
Notice that what the investor has succeeded in doing is reducing the
break-even point on his stock position from the shares' initial cost of
$50 to a lower XYZ stock price of $45. In other words, the repair
strategy does not need the underlying stock to at least partially
recover over the original stock purchase price in order to obtain the
desired result - breaking even on the overall stock repair position.
XYZ rises to $50 at expiration
Should XYZ rally back to the shares'
initial purchase price of $50 by option expiration, the investor's
position will be as follows:
- long 100 shares will break-even
- long 1 XYZ 40 call, now worth $10 (value at option's sale)
- short 2 XYZ 45 calls, each now worth -$5 (cost of options'
repurchase)
The net value of the options equals zero: (-$5 purchase
price x 2 contracts x 100) = ($10 sale price x 1 contract x 100) = $0.
Since the values of the options cancel out and the stock is at its
original cost, the overall position breaks even.
Above an XYZ price level of $50 at expiration, the investor will see a
net loss on net option value. However, this option loss will be offset
by the profit seen on the original share purchase. This is the
"downside" of the repair strategy in this particular case: the best the
investor can do with the total position is to break even.
Changing Opinion?
If XYZ stock has risen to the original purchase price of $50 at
expiration the investor might again become bullish on the stock and no
longer be satisfied with just breaking even at the new reduced
break-even point. In this case, the investor might liquidate the option
position for little or no cost. If he sells the XYZ 40 call for its
intrinsic value of $10 ($50 stock price - $40 strike price), and
purchases the 2 XYZ 45 calls for their intrinsic value of $5 each ($50
stock price - $45 strike price), then he has closed the option position
for no net cost beyond commissions. He would then be left with his
original 100 shares of XYZ and be positioned to profit if they increase
in price.
Summary
The stock repair strategy is ideal for an investor
holding a stock position on which he has an unrealized loss and would be
satisfied to simply break even. It helps the investor by reducing his
stock position's break-even point for little or no out-of-pocket cost.
The strategy does not protect the existing stock position from further
downside loss, but doesn't increase risk on the downside either. In
return, the investor generally gives up any upside potential beyond the
new reduced break-even point.
Determining Strike Prices
One consideration when establishing the repair strategy is which option
should be purchased, and which should be sold. Note that in our example
the unrealized loss on the stock was $10 dollars and the strike price
interval between the options chosen was $5, half the unrealized loss. If
an investor was holding a stock now trading at $90 with an original cost
of $110 (i.e., a $20 unrealized loss), he should look to purchase the
$90 calls and sell the $100 calls - a $10 spread in strike prices. If an
investor purchases at-the-money options, then he should consider selling
out-of-the-money options that are approximately at the halfway mark
between the current stock price and the original acquisition cost.
Can the Repair Strategy be implemented for all stocks that are trading
below the purchase price? Unfortunately not. The strategy will generally
work for stocks that are down 20% from their entry point (using options
that may have 60 to 90 days to expiration), but will prove inadequate
for stocks down 40% or 50%. In the latter cases, investors will find
that selling two out-of-the-money calls will not generate enough premium
to finance the one at-the-money call purchased.
Finally, very often, the strategy can be initiated for a small credit or
a small debit. An investor might still consider the strategy in those
cases were he may have to pay $0.25 or $0.50 for initiating the option
position. In these cases the investor may give up this small debit no
matter how high the stock increases in price. However, he might find
that the overall benefits of the strategy are worth a minimal outlay. On
the other hand, if the option position is established for a small
credit, above the reduced break-even point he might keep this credit.
Final profit & loss scenarios from using the repair strategy will vary
depending on the original stock purchase price, the stock's price when
establishing the repair, the strike prices chosen and whether the option
position is
