Don’t Fret, Salvage Your Losing Position With Options

When facing loss, you have multiple ways to deal with it. Many traders don’t’ consider stock options for “repairing” a losing stock position, either because they are unfamiliar with options, or not sure how to use options to repair an equity position. The “Option Repair” strategy is used by equity traders who are facing a loss and want to reduce their break-even price so they can get out of the trade; furthermore, these option positions can typically be attained at little or no cost.

Ways to Deal with a Large Loss

When facing a loss in a stock, the simplest solution is to sell the stock and take the hit. Another possibility is to wait it out, hoping the stock will eventually get back to your purchase price. Some traders choose to “double down,” buying more stock and creating a lower average purchase price. While this reduces the break-even point it also increases risk if the stock price continues to drop; this is not to mention that they are coughing up more cash to purchase more stock.

The Option Repair strategy is another alternative. Say you purchased 200 shares of Apple (AAPL) at $600 in 2012, then you watched it drop below $400 in 2013. In early 2014 the stock is trading at $523, and you have decided you just want out, but you don’t want to take the $15,400 loss ($120,000 – $104,600). If you can break-even on the trade, you will be happy, and if you can reduce the break-even price without dishing out more capital, even better! That’s exactly what the Option Repair Strategy does.

Option Repair Setup

When facing a loss in a stock, the simplest solution is to sell the stock and take the hit. Another possibility is to wait it out, hoping the stock will eventually get back to your purchase price. Some traders choose to “double down,” buying more stock and creating a lower average purchase price. While this reduces the break-even point it also increases risk if the stock price continues to drop; this is not to mention that they are coughing up more cash to purchase more stock.

The Option Repair strategy is another alternative. Say you purchased 200 shares of Apple (AAPL) at $600 in 2012, then you watched it drop below $400 in 2013. In early 2014 the stock is trading at $523, and you have decided you just want out, but you don’t want to take the $15,400 loss ($120,000 – $104,600). If you can break-even on the trade, you will be happy, and if you can reduce the break-even price without dishing out more capital, even better! That’s exactly what the Option Repair Strategy does.

Option Repair Example

Assume the prior scenario: You purchased 200 shares of Apple (AAPL) at $600. The stock now trades at $523, near the start of April 2014. If you can break-even, you want out, and are willing to give up any profit over and above your break-even price.

Step 1. Calculate the difference between your stock purchase price and the current price, divide it by two, and then add the number to the current stock price. This is the strike price (approximate) where you will sell two calls for each 100 shares you own.

  • In this case, $600-$523=$77. Divide this by 2, and then add it to the current price. So $38.50 + $523 = $561.50. Round this down to $560 (nearest Apple strike price). This is the price you are going sell four call options at (two for each 100 shares).
  • This is also your new break-even price. If the stock price is at $560 when your options expire, your stock loss is eliminated (or very close).

Step 2. Buy one Call for each 100 shares you own, at or near the current market price.

  • In this case, the current price is $523. Round this to $525 (nearest Apple strike price). This is the strike for buying 2 calls (1 for each 100 shares).

Step 3. Choose an expiry. If the price has to cover a lot of distance to reach your new break-even, choose an expiry several months out. If the price doesn’t need to cover much distance, you can choose a shorter expiry.

  • In this case, the price needs to move up $38.50. So assume we choose an expiry two to three months away (If it’s April, expiry is in June). All charts were made with FreeStockCharts.com.
This is the first figure in the article
Figure 1. Key Levels for Option Repair (Apple, Daily Chart)

Step 4. Calculate how much the options cost. Buying the calls (one for each 100 shares) is your cash outlay. Selling the calls (two for each 100 shares) is your income. The source for the following two charts is the BOE.

Figure 2. Apple June Call Options, $525 Strike
Figure 2. Apple June Call Options, $525 Strike
Figure 3. Apple June Call Options, $560 Strike
Figure 3. Apple June Call Options, $560 Strike
  • In this case, the option we buy (near current price) is $19.95, and we need to buy two because we have 200 shares. Total cost: $19.95 × 200 = $3990.
  • The options we sell are priced at $7.78, and we sell four because we have 200 shares. Total income: $7.78 × 400 = $3112
  • Total cost is $3990 – $3112 = $878. This is an additional cash outlay.
  • If the options you are sell are worth more than the options you buy, you pocket some cash on the transaction.

The bigger the loss on the stock position, the more likely it is that attaining the options will cost you money (like above). The smaller the stock position loss, the more likely it is that the option position will cost you nothing or may even generate a small amount of cash inflow [see also Ten Commandments of Futures Trading].

Scenarios

If the stock continues to decline, the options expire worthless, and you’ll still be holding a losing stock. For many positions, the options positions won’t cost you anything, so you are no worse off than if you just held the stock. If the options did cost you something, as in the example above, then you will have lost slightly more by instituting the Option Repair strategy.

If the price rises above where you bought the call, then your loss will be reduced. If the price rises to your new break-even price, then your stock loss will be eliminated. In the example above, if Apple rises to $560 the loss will be erased (or very close to it).

This is because the calls you wrote will expire worthless (unless the price goes above $560). But the 2 calls you bought are now worth $560-$525=$35 × 200 = $7000. The loss on your stock position is nearly the same. You purchased at $600 and the stock is now at $560, a loss of $8000. Instead of losing $8000, your loss is reduced to $1000 ($8000-$7000), plus the cost of options if applicable. This is essentially a rounding error, based on the available strike prices. Alter when you purchase the options, or the strike prices, to completely reduce the loss.

If the price continues above the new break-even price ($560 in the example above), you have the same scenario as the prior. You will have broken even, although in this case there is a “rounding error,” as often happens in the real-world, so you lose $1000 regardless of how high the stock price rises.

Stock at ExpirationGain/Loss on Stock (200 shares)Value of 2 Bought Calls ($525)Value of 4 Sold Calls ($560Net Gain/Loss
$400-$40000$0$0-$40000
$450-$30000$0$0-$30000
$500-$20000$0$0-$20000
$550-$10000$5000$0-$5000
$575-$5000$10000-$6000-$1000
$600$0$15000-$16000-$1000
$650$10000$25000-$36000-$1000

You always have the choice to close out your options positions at any time. Since option prices are always changing, you’ll need to price out what it costs to sell your bought call, and buy back the options you sold.

Final Considerations

Commissions have not been included, as they are not typically a material cost when applying this strategy once in a while.

Strike prices are not available for every price the stock passes through, which means you may not totally reduce your loss, but typically you can get quite close. Sometimes you’ll pay for the option positions; other times you’ll receive cash flow from the options, which can also be used to reduce the stock loss position.

The Bottom Line

The Option Repair strategy typically doesn’t leave you worse off when compared to just holding a losing position. Whether the stock rises or falls, often you will end up better (reduced loss, or small gain), or with a similar loss than if you had not implement the Option Repair strategy.

If you decide to utilize the strategy, be sure to do the math and see how you will fare under different stock price scenarios. By slightly adjusting the options used, you may be able to completely eliminate your stock loss, and possibly even collect some cash flow on the sale of the options.

Cory Mitchell