The Option Repair Strategy

Key Points

  • Stocks don't always go up.
  • Find out how to use options to potentially recover your losses faster if a stock turns against you.
  • We'll look at some examples, as well as the advantages and disadvantages of the "options repair strategy."

Every time you buy a stock, you probably do so with the expectation that it will go up. As you know, that doesn't always happen.

Once you learn the basics of options trading and how options can be used to help reduce risk and increase profits (sometimes both at the same time) you can hedge against these instances beforehand.

Let's say you bought a stock hoping to make a nice profit. However, the stock has moved against you a few points, and you'd be happy just to get back to breakeven. I suspect you'd be open to a strategy that could get you back to breakeven sooner, without taking on a lot of additional risk. The option repair strategy is designed to do exactly this.

How does it work?

Assume you bought 1,000 shares of XYZ at a price of $17.50 in March, but by mid-May the stock has dropped to $14.75 for an unrealized loss of $2,750. Now you find yourself wishing you could just get back to breakeven.

XYZ Heading South

XYZ Heading South

Source: StreetSmart Edge®

Using the option repair strategy, if the stock has not dropped too far (explained below) you might be able to get back to even without the stock needing to rise to your original purchase price. You must still expect the stock to rise slightly.

A 1x2 ratio call spread may be the solution. Consider the following trade:

  • Buy 10 XYZ July 15 calls @ 0.75
  • Sell 20 XYZ July 17.50 calls @ 0.35
  • Net debit = 0.05

The calls purchased are more expensive than the calls sold, but because this is a ratio spread you end up with only a small debit of 0.05 per long contract, or $50 on the trade. In other words, prior to entering this trade you had an unrealized loss of $2,750 and this trade only adds $50 of additional risk.

What's more, while this order would be entered as a 1x2 ratio spread, since you own 1,000 shares of XYZ your resulting positions after the order executes will be a 10x10 bullish call spread and a 1,000 share position with 10 covered calls written against it.

To make this strategy work, you should buy options with a strike price that is very close to the current price of the stock, and sell options with a strike price that is close to the original price you paid for the stock. If the options you sell are trading for much less than half the price of the options you are buying, your stock has probably dropped too far for this strategy to work. This strategy works best when the net cost of the spread is as close to zero as possible.

As illustrated by the blue section of the chart below, while this strategy does add additional risk ($50 in this example), it also creates the potential for a faster recovery of your unrealized losses by lowering the breakeven point on your stock trade from $17.50 to $16.28 if you hold the stock until the July expiration date. The trade-off for this lower breakeven point is that you must be willing to forfeit any possible profit on the stock above $17.50.

A lower breakeven changes the equation

A lower breakeven changes the equation

Source: Schwab Center for Financial Research.

This strategy will generally work because once the stock exceeds the lower strike price, it has positive theta, meaning it benefits from time decay. Since you have twice as many short options as long options, as long as the stock remains between the two strike prices, the short options lose more aggregate time value than the long options. Additionally, above the lower strike price, because the long options are in the money and the short options are not, the long options have a higher delta and thus gain value faster as the underlying stock price increases.

Ideally you want the stock to be between $17.50 (the higher strike price) and $20 (the crossover price) at the July expiration. Once the stock moves above $15, your gains should approach $2 per share for every $1 move in the stock from $15 to $17.50, as expiration approaches.

This occurs because the stock gains $1 and the July 15 calls will start with a delta of 0.50 and approach 1 as the stock rises to $17.50. At the same time the July 17.50 calls will start with a delta of around 0.25 and any gain in delta will be mostly offset by time erosion as long as the stock stays below $17.50.

Your maximum profit of $2,450 will occur if the stock is at or above $17.50 at expiration, but as illustrated by the yellow section of the chart above, you don't want it to be above $20 or you will give up some profit that you would have earned if you had just held the position. This is called the crossover price because it's the price beyond which you would have been better off if you had simply held the equity position and not traded any options.

Breaking it all down

Below are some profit-and-loss outcomes at some sample stock prices at option expiration:

At any price above $17.50:

  • The 20 short 17.50 calls are assigned and you sell 2,000 shares, leaving you short 1,000 shares.
  • The 10 long 15 calls will be exercised to close out your short position at $15 per share.
  • Total profit above $17.50 works out as follows:
  • Original purchase of 1,000 shares      -$17,500
  • Purchase of 10 July 15 calls                -$750
  • Sale of 20 July 17.50 calls                    $700
  • Assigned on 17.50 calls                        $35,000
  • Exercise 15 calls                                  -$15,000
  • Net gain                                                $2,450

Compare this to a profit that would be higher on the stock alone as it rises above $20.

At $17.50:

  • The stock can be sold at $17.50 for breakeven.
  • The 20 short 17.50 calls which were sold for 0.35 expire worthless for a gain of $700.
  • The 10 long 15 calls which were purchased for 0.75 can be sold at 2.50 for a gain of $1,750.
  • Total profit: $0 + $700 + $1,750 = $2,450.

Compare this to breakeven on the stock alone.

At $17:

  • The stock can be sold at $17 for a loss of $500.
  • The 20 short 17.50 calls which were sold for 0.35 expire worthless for a gain of $700.
  • The 10 long 15 calls which were purchased for 0.75 can be sold at 2 for a gain of $1,250.
  • Total profit: -$500 + $700 + $1,250 = $1,450.

Compare this to loss of $500 on the stock alone.

At $16.28:

  • The stock can be sold at $16.28 for a loss of $1,220.
  • The 20 short 17.50 calls which were sold for 0.35 expire worthless for a gain of $700.
  • The 10 long 15 calls which were purchased for 0.75 can be sold at 1.28 for a gain of $530.
  • Total profit: -$1,220 + $700 + $530 = $10.

Compare this to loss of $1,220 on the stock alone.

At $16:

  • The stock can be sold at $16 for a loss of $1,500.
  • The 20 short 17.50 calls which were sold for 0.35 expire worthless for a gain of $700.
  • The 10 long 15 calls which were purchased for 0.75 can be sold at 1 for a gain of $250.
  • Total loss: -$1,500 + $700 + $250 = -$550.

Compare this to loss of $1,500 on the stock alone.

At $15:

  • The stock can be sold at $15 for a loss of $2,500.
  • The 20 short 17.50 calls which were sold for 0.35 expire worthless for a gain of $700.
  • The 10 long 15 calls which were purchased for 0.75 expire worthless for a loss of -$750.
  • Total loss: -$2,500 + $700 - $750 = -$2550.

Compare this to loss of $2,500 on the stock alone.

At any price below $15, the loss would always be $50 more than on the stock alone.

Know what you're giving up

While the option repair strategy has its merits, be sure you are clear on the following limitations:

  • While the breakeven is lower, the profit potential is also capped.
  • If the stock increases dramatically, opportunity for profits beyond the higher strike price are eliminated.
  • This strategy does not provide any downside protection and actually creates $50 more downside risk.
  • Your account must be approved for spread trading to implement the strategy.
  • These examples don't account for commissions or tax considerations, which could significantly reduce the potential benefits of the strategy.

Good luck and good trading.

 

Next Steps

Schwab clients: Contact a Trading Specialist at 800-435-9050 for questions or log in to the Trading Services Learning Center.
Not yet a client? Learn more about Schwab Trading Services.

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