Stock Repair Strategy

[Igor 10]

Traders who carry out a stock repair strategy try to recover losses on their long positions sustained from an earlier period. The technique involves implementing a call ratio spread, usually 2:1, consisting of buying one call option and selling two. A rise in the market repairs a trader's losses. The call ratio spread can repair losses in a bear market, up to the ratio's breakeven point.

 

The Differences Between ITM, ATM and OTM for Puts and Calls

There are five ways to define the relationship between an option's strike price and the market price of its underlying asset for puts and calls. Understanding the differences between the terms is important when considering the risks involved in implementing a stock repair strategy.

 

Put Options:

ITM - In The Money: The underlying asset's market price is less than option's strike price.

OTM - Out of The Money: The underlying asset's market price is more than option's strike price.

 

Call Options:

ITM - In The Money: The underlying asset's market price is more than option's strike price.

OTM - Out of The Money: The underlying asset's market price is less than option's strike price.

 

Both Put and Call Options:

ATM - At The Money: The underlying asset's market price equals the option's strike price.

 

How to Implement a Stock Repair Strategy

Precondition:

**XYZ is worth $50 (market price) in May

**Trader buys 100 XYZ shares for $5000 (100 x $50 share cost))

**XYZ declines to $40 (market price) in June

**Trader loses $1000 on paper [-$1000 = $4000 (current market value) - $5000 (investment cost)]

 

 

Stock Repair (2:1 Ratio):

XYZ is worth $40 (market price)

1) Trader buys one call option: XYZJul40($2)

- 100 shares of XYZ stock

- Strike Price $40 (ATM), expiring in 30 days

- Premium Cost of $2

2) Trader writes (sells) two calls options: XYZJul45($1)

- 100 shares of XYZ stock

- Strike Price $45 (OTM), expiring in 30 days

- Premium Cost of $1

3) Trader pays nothing to repair the stock because the premiums offset each other [$200 (paid for call) - $200 (received from put)].

 

Result one: XYZ hits $45

a) The two call options sold expire worthless (OTM).

b) The call option purchased is ITM. The trader exercises his or her right to buy 100 shares at $40, pays $4000 to the seller and sells the shares in the open market for $4500.

c) The trader also sells his or her long position for $4500.

d) The trader makes a total profit of $1000 [$1000 = $500 (profit from call) + $500 (profit from long)]. The $1000 repairs the trader's loss from a month earlier.

 

Result two: XYZ hits $60

a) The two call options sold are ITM. The call buyer exercises his or her right to buy 200 shares at $45.

b) The call option purchased is ITM. The trader exercises his or her right to buy 100 shares at $40, pays $4000 to the seller.

c) The trader delivers 200 shares (100 from the long position and 100 from call purchase) to the call buyer, and he or she receives $9000.

d) The trader makes a total profit of $5000 from the current month's trading [$9000 (received from call sale) - $4000 (paid for call purchase)].

e) The trader actually breaks even because the $5000 profit offsets the $5000 that trader paid to enter the market a month ago before the loss. [$0= $5000 (profit from current month) - $5000 (cost of investment)].

 

Result three: XYZ hits $30

a) The two call options sold expire worthless (OTM).

b) The call option purchased expires worthless (OTM).

c) The trader keeps his or her long position and loses another $1000 in paper value [-$2000 = $3000 (current market value) - $5000 (investment cost)].

 

Advantage and Disadvantage of Implementing a Stock Repair Strategy:

 

Pluses: The upside to this type of strategy is that the investor pays nothing to repair the stock, and he or she will always recover losses in a bull market. Another advantage in using a stock repair strategy is that even if the market continues to fall, traders can still recover their losses up to the call ratio's break even point.

 

Minuses: The downside in using a stock repair strategy is that if the market falls past the call ratio's break even point, the long position will continue to lose value.