Stock options have a myriad of applications. With our covered-call writing and put-selling strategies, we seek to generate cash-flow in a low-risk manner, explains Alan Ellman of The Blue Collar Investor.

Another utilization of stock options is to mitigate losses when share price declines. This is known as the stock repair strategy. It is used when a stock is purchased (with no option component) and share price declines significantly. Options can be leveraged to mitigate.

What is the Stock Repair Strategy?

When shares are owned at a higher price than current market value, the breakeven price point is lowered by purchasing one near-the-money call option and funding that purchase by selling two out-of-the-money call options with strikes between current market value and original purchase price. This also known as a 1 x 2 ratio call spread.

Advantages of the Stock Repair Strategy

The breakeven is lowered without adding any significant amount of cash to the trade. There may be a small option debit but there also can be a small option credit. This can replace averaging down where additional shares are purchased at a lower price to lower the breakeven. With the latter approach, additional cash is added to an already losing trade.

Disadvantages of the Stock Repair Strategy

We must be willing to forego potential profit in exchange for lowering the breakeven price point. The trade does not protect us from continuing share price decline.

Real-Life Example with Lyft Inc. (LYFT) (Price Decline from $64.16 to $52.61 in One Month)

LYFT Price Chart April – May 2021
LYFT Price Chart April – May 2021

Stock Repair Strategy for LYFT to Lower the Current Breakeven of $64.16

  • 1 x $52.50 near-the-money call option is purchased for $3.75
  • 2 x $57.50 out-of-the-money call options (both covered) are sold for $1.75
  • The 1 x 2 ratio call spread results in a net debit of $0.25
  • The breakeven is lowered from $64.16 to $58.46 by adding only $0.25 per-share
  • Since we are dealing with stock options, we must use the strategy in 100 share increments

The BCI Stock Repair Calculator

LYFT Stock Repair Calculations
LYFT Stock Repair Calculations

Final trade results are calculated by adding closing trade results in the two white cells at the top of the spreadsheet (currently blank) and checking results in the green cells at the bottom of the spreadsheet.

Discussion

The stock repair strategy will lower our breakeven price point by adding little or no cash to the trade. There may actually be an option credit in many cases. We must be willing to sacrifice potential upside profit and understand that we are still susceptible to further share price decline.

Learn more about Alan Ellman on the Blue Collar Investor Website.