An Options Strategy That May Help Recover Your FB Losses At Little Or No Cost

[OlmsteadOptions 10]

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.