The Stock Repair Strategy

Today's Guest Blogger is Dan Passarelli of Market Taker Mentoring. Dan is an options guru with more than 17 years experience in the options industry. He has worked as both a floor trader and an options instructor. Today Dan is going to share his insight on the "stock repair strategy." What are some tricks you use to leverage risk in trades? Be sure to comment below and visit Dan at Market Taker Mentoring.

-----------------------------------------------------------------------------------------------------------------------------------------

It’s been a rough ride for a lot of investors. Some investors are waiting (patiently) for the market to turn around. Some traders are buying at the new, cheaper prices. But as experienced investors know, the market can always go lower—sometimes fast and furiously. There is one more alternative that can make sense in some cases: the stock repair strategy.

Introduction to the Stock Repair Strategy:
The stock repair strategy is a strategy involving only calls that can be implemented when an investor thinks a stock will retrace part of a recent drop in share price within a short period of time (usually two to three months).

The stock repair strategy works best after a decline of 20 to 25 percent of the value of an asset. The goal is to “double up” on potential upside gains with little or no cost if the security retraces about half of its loss by the option’s expiration.

Benefits
There are three benefits the stock repair strategy trader hopes to gain. First, little or no additional downside risk is acquired. This is not to say the trader can’t lose money. The original shares are still held. So if the stock continues lower, the trader will increase his loses. This strategy is only practical when traders feel the stock has “bottomed out”.

Second, the projected retracement is around 50 percent of the decline in stock price. A small gain may be marginally helpful. A large increase will help but have limited effect.

Third, the investor is willing to forego further upside appreciation over and above original investment. The goal here is to get back to even and be done with the trade.

Implementing the Stock Repair Strategy
Once a stock in an investor’s portfolio has lost 20 to 25 percent of the original purchase price, and the trader is anticipating a 50 percent retracement, the investor will buy one close-to-the-money call and sells two out-of-the-money calls whose strike price corresponds to the projected price point of the retracement. Both option series are in the same expiration month, which corresponds to the projected time horizon of the expected rally. The “one-by-two” call spread is ideally established “cash-neutral” meaning no debit or credit. (This is not always possible. More on this later). To better understand this strategy, let’s look at an example.

Example
An investor, buys 100 shares of XYZ stock at $80 a share. After a month of falling prices, XYZ trades down to $60 a share. The investor believes the stock will rebound, but not all the way back to his original purchase price of $80. He thinks there is a reasonable chance for the stock to retrace half of its loss (to about $70 a share) over the next two months.

The trader wants to make back his entire loss of $20. Furthermore, he wants to do it without increasing his downside risk by any more than the risk he already has (with the 100 shares already owned). The trader looks at the options with an expiration corresponding to his two-month outlook, in this case the March options

The trader buys 1 March 60 call at 6 and sells 2 March 70 calls at 3. The spread is established cash-neutral.

Bought 1 Mar 60 call at 6
Sold      2 Mar 70 call at 3 (x2)
-0-

By combining these options with the 100 shares already owned, the trader creates a new position that gives double exposure between $60 and $70 to capture gains faster if his forecast is right. FIGURE 1 shows how the position functions if held until expiration.

Figure 1

If the stock rises to $70 a share, the trader makes $20, which happens to be what he lost when the stock fell from $80 to $60. The trader would be able to regain the entire loss in a retracement of just half of the decline. With the stock above 60 at expiration, the 60-strike call could be exercised to become a long-stock position of 100 shares. That means, the trader would be long 200 shares when the stock is between $60 and $70 at expiration. Above $70, however, the two short 70-strike calls would be assigned, resulting in the 200 shares owned being sold at $70. Therefore, further upside gains are forfeited above and beyond $20.

But what if the trader is wrong? Instead of rising, say the stock continues lower and is trading below $60 a share at expiration. In this event, all the options in the spread expire and the trader is left with the original 100 shares. The further the stock declines, the more the trader can lose. But the option trade won’t contribute to additional losses. Only the original shares are at risk.

Benefits and Limitations of the Stock Repair Strategy
The stock repair strategy is an option strategy that is very specific in what it can (and can’t) accomplish. The investor considering this option strategy must be expecting a partial retracement and be willing to endure more losses if the underlying security continues to decline. Furthermore, the investor must accept limiting profit potential above the short strike if the stock moves higher than expected.

Best of luck,
Dan Passarelli
Market Taker Mentoring

---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Special Bonus for Traders Blog Readers: 25% off Dan's February Online Options Education Series, Using the Greeks to Find, Manage and Adjust Option Trades. Learn everything you've ever wanted to know about options and greeks LIVE from one of the most respected names in the field.

10 thoughts on “The Stock Repair Strategy

  1. Can you use this strategy when you have shorted a stock and the stock has went up? For example:
    An investor, shorts 100 shares of XYZ stock at $60 a share. After a month of XYZ trades up to $80 a share. The investor believes the stock will rebound, but not all the way back to his original purchase price of $60. He thinks there is a reasonable chance for the stock to retrace half of its loss (to about $70 a share) over the next two months.

  2. Can you please explain what determines call price here ? e.g. it says Buys 1 March 60 call @6 and Sell 2 March 70 call @ 3

    >>The trader buys 1 March 60 call at 6 and sells 2 March 70 calls at 3

    WHat determines price @6 or @3, basically net effect of buying option is zero here but is it possible in real ?

  3. Albert,

    All strategies have a time and a place. The Stock Repair Strategy isn't always practical, but under some circumstances is very useful. One would ONLY use this strategy if he or she expects the stock will not decline further and will retrace half the gains. If that scenario plays out, it works fantastic.

    The strategy you suggest may sometimes work as well (again, depending on the situation). But if implied volatility is high, you'll have a hard time getting good prices 1) because the puts will be really expensive and two, you take on lots of vega risk that could lead to disaster if IV gets crushed. Plus, if the stock gravitates to the long strike in the backspread and is still there at expiration you can loose quite a bit.

    The two strategies have different risks and are appropriate for different scenarios where the trader has different expectations.

    Thanks for the suggestion!

    Dan

  4. This strategy is not worth it. Rather than chasing a losing trade, you should cut your losses and invest in another position. Capping your upside gains and still exposed to erosion of value on your shares is the opposite of what you should be doing.

    You are much better off buying a put to protect the shares on the downside and simultaneously opening a long ratio backsprea for a credit, covering the put option price.

    This gives you downside protection on your naked shares PLUS you recover your losses faster when price rallies IN ADDITION to having unlimited gains if price skyrockets. All this with only spending a tiny bit or nothing if your ratio backspread gave you a big enough credit.

  5. you bought 1 option 100 shares, u sold 2 option 200 shares, but u already owned 100 shares of stock, so its not naked

  6. Don,
    If you already own 100 shares, you can write a (1) covered call option on those shares. The other contract is covered by the purchase of the near the money call. Not to be smug, but go read the example again. That may help explain.

    Tom

  7. How can you sell 200 shares {2 calls} when you own only 100 shares..unless your into naked options?

    1. Don,

      That's a question for your broker to answer. As we are not brokers at MarketClub we are not comfortable giving any advice like that.

      All the best,
      Adam

Comments are closed.