Stock repairs have limited profit potential, and while they do not define risk to the downside, the ratio spread-like structure lowers the break-even price on a long stock position held at a loss. The income collected from selling the spread helps increase the probability of recovering from the loss of the long stock position. A stock repair may be entered at no cost or for a credit.
Stock Repair market outlook
The stock repair strategy is utilized when an investor has incurred losses on a long stock position and wants to reduce the necessary price increase required to break even. The strategy limits future upside potential but is an alternative to simply holding the shares and waiting for the stock price to recover and/or adding shares to lower the original trade’s cost basis, which requires risking more capital. However, the best the stock repair strategy will do is break even on the original trade, but this comes at no further downside risk than already owning the shares of stock.
How to set up a Stock Repair
Stock repair is essentially a call ratio spread combined with a long stock position and consists of buying an at-the-money call and selling two out-of-the-money calls at a higher price. The strategy is used if the stock price has decreased since ownership was initiated. Therefore, the at-the-money long call option will be below the cost basis of the long stock shares. The short options become the break-even price for the original stock position.
The ratio spread may be opened at no cost, or result in a credit, and will help to lower the cost of the initial trade.
Stock Repair payoff diagram
The payoff diagram for a stock repair strategy combines the profit and loss outcomes of long stock ownership and a call ratio spread. The maximum potential profit will now be limited to the strike price of the short call options. However, the break-even point will now be reduced.
For example, if 100 shares of stock were purchased at $50, and the stock is now trading for $40, a stock repair strategy could be used to help reduce the cost of the position. One buy-to-open (BTO) order for a long call option is entered at-the-money of the current stock price of $40. Two sell-to-open (STO) orders for short call options are entered out-of-the-money above the long options at $45. If the long call is purchased for $400 and the short calls are sold for $200 each, the net cost of the position is $0. If the stock stays below $40, all options expire worthless.
A similar strategy could be employed for the next expiration month. If the underlying stock closes above $40 but below $45 at expiration, the short calls expire worthless, and the long call can be sold for its intrinsic value, which would bring in more credit and reduce the break-even point of the original stock position. The investor could choose to close his long shares of stock or open a new position for a later expiration date. (For example, if the stock was at $42, the stock repair would have collected $200. Selling the stock would result in a -$600 loss, which is better than the -$800 it would have experienced without the strategy).
If the stock price closes above $45 at expiration, all options will be in-the-money. The long call and one short call will cancel out, and the remaining short call would sell shares of stock at $45. This would result in a break-even result for the stock repair as the $500 gain on the long call cancels out the $500 loss on the long stock position. The downside is that if the stock position closes above $50, the position will still only break even.
Entering a Stock Repair
Stock repair is a call ratio spread and consists of buying an at-the-money call and selling two out-of-the-money calls at a higher price for every 100 shares of stock owned. All three options have the same expiration date. The strategy is used on a stock position that has an unrealized loss in an attempt to reduce cost basis and increase the chances of breaking even.
The stock repair strategy is opened with the at-the-money long call at a strike price lower than the stock’s original purchase price. The short options are sold at a higher price and must offset the cost, or collect more money, than the cost to purchase the long call for the strategy to be effective.
For example, if 100 shares of the stock were purchased at $50 and are now trading at $40, the stock repair may be entered with buying-to-open (BTO) one long $40 call and selling-to-open (STO) two short $45 call options, all with the same expiration date. If the long call is purchased for $400, the two short options should collect at least $400 of credit for the strategy to be successful.
Exiting a Stock Repair
The mechanics of exiting a stock repair strategy will depend on the underlying stock price at expiration. If the stock price is above the short calls, all options will expire in-the-money, and the shares of stock will be sold at the strike price of the short calls. If the stock closes between the long call and short calls, the short calls will expire worthless, and the long call will be in-the-money. The long call and the stock could be sold simultaneously, or the long call could be sold for its intrinsic value, and a new repair strategy could be opened with a later expiration date. If the stock closes below the long call, all options expire worthless. The credit, if any, from the strategy would remain, but the overall position would still show a net loss, and a new repair strategy could be opened with a later expiration date.
Time decay impact on a Stock Repair
The effects of time decay are minimal on the stock repair strategy. The short calls are positively impacted by theta decay, while the long call is negatively impacted. However, the strategy is not looking to capitalize on time decay to be profitable, so it is not a factor in whether the stock repair is successful. The longer the options are from expiration when the strategy is initiated, the more the options will be worth, but this will apply to all of the options.
Implied volatility impact on a Stock Repair
The effects of implied volatility are minimal on the stock repair strategy. Implied volatility values will impact the pricing of the options when the position is opened, but all options will be affected similarly.
Adjusting a Stock Repair
Stock repair strategies are not typically adjusted during the trade. The strategy’s goal is to reduce the original stock position’s cost basis and lower the break-even point to a more realistic price. If the price of the underlying stock continues to fall, the short calls may be purchased and resold at a lower price, which will bring in more credit but will force the investor to sell shares of stock at a lower price if the stock is called away. If the credit received did not cover the lower strike price, the adjustment will result in a loss.
A stock repair may be adjusted if the investor decides they no longer want to break-even on the trade and believe the stock will continue to rise. If the stock price increases, the short calls could be purchased and either resold at a higher price and/or later expiration date. The position could be exited completely, but buying back the calls will cost more money than the position was initially opened for, so the outlook for the stock would need to be very bullish to eventually exceed the additional cost added to the position.
Rolling a Stock Repair
The stock repair may be rolled if the underlying stock price is above the long call strike at expiration, and the investor wishes to extend the position. Any in-the-money options could be bought or sold and reopened at a later expiration date and different strike prices if the stock price has changed. The stock repair position may be rolled if the underlying stock price is below the long call strike at expiration, and the investor wishes to extend the position for additional time to break even on the long stock position. Any in-the-money options could be bought or sold and reopened at a later expiration date and different strike prices if the stock price has changed.
Hedging a Stock Repair
Stock repairs are not typically hedged because the option strategy is an attempt to lower the break-even point on a position trading at a paper loss. Downside protection is not considered with a stock repair. Other options strategies should be considered if downside protection is desired.
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