Stock Repair Option Strategy, as the name indicates, is used to recover from the loss suffered on going long on a stock that has now fallen in price. Investors who are looking forward to cost averaging their position when the underlying stock price is falling can apply the stock repair strategy.
This strategy limits future upside potential but provides an alternative to simply holding the shares and waiting for the stock price to regain and/or risking more capital by adding shares to lower the original trade’s cost basis. However, at best the stock repair option strategy will break even on the original trade, but this comes at no further downside risk than already owning the shares of stock.
How it Works (Implementation)
Stock repair is essentially a call ratio spread built with an existing long stock position and is constructed by buying one at-the-money call and simultaneously selling two out-of-the-money calls at a higher strike price. It is used when the stock price has substantially decreased after acquiring the ownership. Therefore, the at-the-money long call option will be below the cost basis of the long stock shares and short options become the break-even price for the original stock position. The ratio spread may be initiated at no cost, or result in a credit, and will help to lower the cost of the initial trade.
The premium received from selling two call options is enough to cover the cost of the one call option, and hence the result is a “free” option position that lets you break even on your investment much more quickly.
Example Using MarketXLS Template
Get the template here: https://marketxls.com/template/stock-repair-strategy/
We will be using MSFT, expiry date as 24 April 2021, ATM strike price is 260, OTM strike price is 265, and the buy price and quantity of the long losing stock is 270 and 100. Voila, we have built a Stock Repair Strategy for MSFT.
Currently, we have a losing long stock position in MSFT. We have bought 1 ATM $260 call option contract and sold 2 OTM $265 call option contracts of MSFT. We have built the net debit strategy which is reflected in the net cash flow section.
Now, let’s check out the payoff schedule and payoff diagram alongside.
Since it is a loss recovery strategy, the maximum gain you can make using this strategy is to recover all the losses that you have been facing in the losing long stock position. There is no additional downside risk to this repair strategy and losses from a further drop in stock price will be no different from the losses suffered if the trader had simply held on to the shares. However, if the stock price drops even more at expiration, then all the options involved will expire worthlessly and there will be no additional loss from the call ratio spread. However, the long stock position will continue to remain at a loss.
In short, the Stock Repair strategy helps in minimizing the loss at very low or no cost as compared to the “Doubling Down” of position.
MarketXLS provides a template for this strategy and allows users to understand and plan it better. The yellow cells have to be inputted by the user. Here, Provide the Stock Ticker, Expiry Date, ATM, and OTM strike price for the call, Buy Price, and Quantity of the Long Losing Stock for the strategy. Upcoming expiry dates are available for reference.
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