Many investors have experienced a loss on an investment and simply want to break even on the trade. Unfortunately, this isn't possible without committing more capital to your losing position in order to "average in" at a lower price. Or is it? The Stock Repair is an options strategy that lets you give up any profit potential in exchange for a new, reduced break even point, without committing any new capital!
The Stock Repair involves purchasing one call option and selling two call options for every 100 shares held. The purchased call option should be at-the-money while the two sold should be at a higher strike price with both expiring in the same month. The positions are structured such that the investors cash outlay is minimal or none, since you get a credit for the two sold and only a small debit for the one purchased.
Let's take a look at an example provided by the CBOE:
An investor has purchased 100 shares of XYZ stock at $50 and seen the value of these shares fall to the current price of $40. He is not willing to invest more capital to this losing stock position, doesn't want any more downside risk than he already has, and is happy to just break even. He decides to establish a repair strategy.
This investor could purchase 1 60-day XYZ 40 call at $3.00 and simultaneously sell 2 60-day XYZ 45 calls at $1.50, a strategy that by itself could be referred to as a "ratio call spread" Note that in this case the spread costs the investor no debit (or credit). The cost of the purchased calls ($3.00 x 100 = $300) is fully offset by premium received from the sale of the written calls ($1.50 x 2 x 100 = $300).
The purchase of the 1 XYZ $40 call, gives the investor the right to purchase an additional 100 shares at a cost of $40 per share. The 2 written $45 calls means that the investor could be obligated to sell 200 shares of XYZ at $45 if assigned. Currently, the investor holds only 100 shares, but if needed the long $40 call could be exercised and another 100 shares purchased at $40 to cover the assignment.
The result is a position whereby any additional losses are absorbed by the investor, but the break even point is now only $45 instead of $50 - a 10% difference. As you can probably guess, the downside of this strategy is that it does not protect against future losses. So, the strategy should only be used in cases where the investor expects the stock to recover at some point in the near future.
The other downside to this strategy is that you forfeit any future gains. Sometimes it is possible to roll-over the call options to higher strikes in order to open up the door for profits, but usually it's a better idea to simply exit the stock and then establish a new position. In the end, this is a good idea when investors want to break even at the expense of upside and feel confident in a near-term turnaround.
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