When Your Stock's Broken, Don't Despair When You Can Repair

10/03/2014 8:00 am EST

Focus: STRATEGIES

Steve Smith

Reporter (Options Columnist), Minyanville

Steve Smith of Minyanville.com illustrates how an options-based stock repair strategy can quickly recoup losses with very little additional risk.

In general, I don't like throwing good money after bad by adding to a losing position.

We can talk often ourselves into doing so by using phrases like "buying the dip" and "averaging down." 

But the truth lies somewhere in between.

For example, an individual stock position may go against you due to broader market or sector news. Or an ETF you jumped on when it hit the 20-day moving average may look even better when it drops to the 200.

If a dip is perceived to be temporary, an options-based stock repair strategy can quickly recoup losses with very little additional risk. 

Some recent situations might include the sell-off in CVS (CVS) after competitor Walgreen (WAG) took hit for cancelling plans for a tax inversion.

CVS tumbled some 4% on the opening even though its operations have zero to do with what's going on with Walgreen's deal activities.

Or take Michael Kors (KORS) and Buffalo Wild Wings (BWLD) which both dropped sharply following earnings despite the fact both reports were solid.

Let's use United Parcel Service (UPS) as an example to illustrate how a stock repair strategy works. It took a hit on earnings, but, for the sake of argument, let's say we're still bullish on it.

Assume we went long 1,000 shares of UPS at $102 the day before the July 29 earnings report. When the stock was trading at $96, we were staring at a $6,000 loss.  

The basic construction is to buy a ratio call spread for no cost or even a credit. This will provide more upside exposure, allowing us to recoup losses on a smaller move higher but not incurring additional risk.

For example, in UPS one could:

  • Buy 10 October $95 calls for $2.70 a contract
  • Sell 20 October $97.50 calls for $1.60 a contract

This is a $0.50 net credit per lot for a 1x2 spread. For every $2.70 spend on a $95 call, we are receiving $3.20 for selling two $97.50 calls.

In total, this would work out to $500 for a 10x20 contract position.

The new position is can now be viewed in two parts:

  1. A 1,000 share covered call position with $97.50 as the cap (using 10 of the $97.50 calls).
  2. A 10 contract $95/97.50 bull call spread.

If shares rise above $97.50, the covered call the stock will be called away at an affective sale price of $99.10. That is the strike plus the premium sold. $97.50 + $1.60 = $99.10.

On the original 1,000 shares, this would represent a $2,900 loss. This is the difference between the purchase price of $102 per share and the effective sale price of $99.10, multiplied by 1000 shares.

The call spread will be fully in the money and worth $2.50, delivering a $1.40 profit or $1,400 for the 10 contracts.

The net result, assuming we closed out the position, would have been to reduce the total loss to just $1,600 on a move up to $97.50.
If one had merely held the stock, would still have a $4,500 loss at the $97.50 price level ($102-$97.40 x 1000 shares).

By collecting a premium for the 1x2 spread, there is no additional downside risk beyond the original 1,000 shares. In fact, the premium actually provides a small amount of downside protection.

Note that the numbers become more attractive for stocks whose options have high implied volatility readings. This allows for greater credits or higher strike prices that allow more money to be recouped, or even a profit to be realized, if shares bounce back.

So the next time one of your stocks sinks, don't despair when you can repair.

By Steve Smith, Contributor, Minyanville.com

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