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Dr. Edward Olmstead, Professor, Northwestern University Chief Options Strategist, Dr. Olmstead’s Options Trading Strategies We've all experienced the situation in which we buy a 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 regains only part of its lost value. Holders of Facebook (FB) stock and those who are under water with Apple (AAPL) may find this strategy useful. The stock repair strategy uses options to assist in bringing your stock investment back to a break-even level. This strategy is structured to attain the break-even status at a stock price that is significantly lower than the original purchase price. The great appeal of this strategy is that it involves no additional risk since it can be applied for little or no additional expense. Note that to do the stock repair strategy for little or no cost, it typically requires options with at least two months until expiration. The more time allowed, the more likely a credit will be generated. Stock Repair Strategy For this strategy to work, it is necessary for your fallen stock to make at least a partial recovery. The stock repair strategy uses options to expand that partial recovery into a full recovery of your original investment, with little or no additional expense. If the stock price remains unchanged or continues to fall, this strategy offers no help. The basic plan is to buy one at-the-money call for each 100 shares of stock that you own. You are going to pay for this one long call by selling two out-of-the money calls with the same expiration date. The idea is to use the cash received from the two short calls to pay for the one long 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. Let's look at some examples to illustrate the stock repair strategy: ‑ Example 1. You bought 100 shares of XYZ back in December when it was $35. You watched it initially go up, but then *undergo a dramatic slide to its current price in early March of $23. You still like the stock and feel that there is some hope for a recovery, although getting back to break-even at $35 seems far away. Let's see how stock repair might help. ‑ Trade: Buy 1 Jun 25 call for $3.30 per share and sell 2 Jun 30 calls for $1.75 per share. This actually produces a net credit of $.20 per share [(1.75 ¥ 2) - 3.3 = .20]. Position: Along with an extra $.20 per share in your account, you hold the combination of a covered call (long 100 shares XYZ and short 1 Jun 30 call) and a bull call spread (long 1 Jun 25 call and short 1 Jun 30 call). See Figure. 16-1 for a risk graph that depicts this position. Payoff: If XYZ is above $30 at the June options expiration, the stock will be called away at $30 per share, for a $7 per share gain over its present price of $23. The bull call spread will be worth $5 per share. The total gain (including the $.20 credit received) is $12.20 per share [7.0 + 5.0 + .2 = 12.2], which is equivalent to a stock price of $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. You bought 100 shares of YZX back in December when it was $19.50. Now in early March the stock is down 15 percent with a slide to $16.50. Let's see how stock repair can get you back to slightly better than break-even in only 10 weeks with the stock recovering just 6 percent from its *current level. Trade: Buy 1 May 15 call for $2.40 per share and sell 2 May 17.5 calls for $1.10 per share. This does require a small cash outlay, specifically $.20 per share [(1.1 ¥ 2) - 2.4 = -.2]. Position: It has cost you an extra $.20 per share to hold the combination of a covered call (long 100 shares of YZX and short 1 May 17.5 call) and a bull call spread (long 1 May 15 call and short 1 May 17.5 call). Payoff: If YZX is up by only 6 percent from its current level 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. Allowing for the small extra cost to establish this trade, the net gain is $3.30 per share [1.0 + 2.5 - .2 = 3.3], which is equivalent to a stock price of $19.80. Thus, you have reached slightly better than break-even with the stock recovering less than half of its loss. In comparing Examples 1 and 2, note that the stock repair for 1 was done for a small credit, whereas 2 required a small debit. The explanation for this is the amount of time until the options expire (June versus May). Reminder: to do the stock repair strategy for little or no cost, it typically requires options with at least two months until expiration. The more time allowed, the more likely a credit will be generated. Dr. Olmstead can be found at http://www.olmsteadoptions.com, an on-line options trading site, centered around options education material and option trading strategies he’s developed. He is Professor of Applied Mathematics at Northwestern University, author of the popular and highly-praised options book, Options for the Beginner and Beyond (2006) and former chief strategist for The Options Professor on-line newsletter, distributed by Zacks.com and Forbes.com.

Dr. Edward Olmstead, Professor, Northwestern University Chief Options Strategist, Dr. Olmstead’s Options Trading Strategies We recognize that when it comes to trading options, there's a lot of information to absorb and most people may not have the time to review every detail, so we put together a "cheat sheet" to help you get started. Should you want to explore any or all of these points further, more detail for each item on the check list is provided in our options blog. Following each of these steps does not guarantee a successful trade, but it reduces the risk of a bad trade and that can make a big difference in your overall trading record. Ten Things to Consider BEFORE You Buy an Option 1. Determine how much of your total investment funds you are willing to use for the high-risk trading of options. Once you have determined an appropriate amount for your options trading capital, allocate only about 15% of that capital per option trade. 2. Make sure you are using an options friendly broker. The trading platform for your account should display option prices in real time and easily allow you to execute a trade when the time is right. Live help should be readily available when you need it. Commissions should not be excessive. 3. Anticipate events that might impact the price action of the stock associated with your option. Check on upcoming earnings release dates, FDA decisions, court rulings, ex-dividend dates, etc. Such events can even be the basis for timing an option trade. 4. Review price trends, not only for your stock of interest, but also for the industry that includes your stock, as well as for the overall market. The cliché "The trend is your friend" is good advice in trading options. The more trends going your way, the better are your chances of success. 5. Select an option that gives you the best opportunity for a successful trade. The cheapest option is rarely the best choice. Choose an option with an expiration date that gives the underlying stock ample time to make the expected move in price. Keep in mind that in options trading, time is money. 6. Learn how to enter an option trade at the best available price. Follow options prices in real time, and enter a limit order that is most likely to be filled. Avoid market orders. 7. Set up a scheme to track your option trade with daily entries in a spreadsheet. It is important to develop a feel for how an option price changes in response to changes in the stock price and the passage of time. 8. Have an exit plan for profit. Decide on a reasonable move in the stock price for a suitable profit to be achieved in the option. The amount of profit will depend on how quickly the stock price reaches the desired level. If the profit comes quickly, you might consider holding on for a bigger gain, but remember that options are time limited. Don't be greedy. 9. Have an exit plan to limit loss. Identify a stock price level that suggests a failure of the move that had been anticipated. When the stock price reaches the failure level, exit the trade to limit loss. Not all option trades will be winners, so it's important to exit a losing trade early and preserve capital for future trades. 10. Gain access to a program that includes an options calculator or risk graph display. Having an unbiased source to check the profit and loss characteristics for your trade is a valuable tool. Some brokers provide such a tool on their trading platform. Dr. Olmstead can be found at http://www.olmsteadoptions.com, an on-line options trading site, centered around options education material and option trading strategies he’s developed. He is Professor of Applied Mathematics at Northwestern University, author of the popular and highly-praised options book, Options for the Beginner and Beyond (2006) and former chief strategist for The Options Professor on-line newsletter, distributed by Zacks.com and Forbes.com.