We just presented a webinar about trading in Volatile Markets and we discussed using the stock repair strategy. The stock repair strategy has the goal of lowering the breakeven of a stock position which is currently at a loss, without doubling up and committing more cash to a losing position. The full webinar is viewable on the archive, but I had a question after the webinar asking for a comparison of the stock repair with simply selling a covered call. Great question which I want to share my comparison here:
To: [email protected]
Sorry I missed the live seminar but I watched it later. Question; what advantage would the stock repair strategy have over just outright selling an out of the money covered call on a stock that moved against you?
Great question! I am very happy you asked this – I should have compared the stock repair to the covered call strategy in addition to comparing just holding (the stock) and hoping (the price recovers).1
In many cases the difference between strikes of the two calls used in the ratio spreads would be a bit wider than the example I used with the IWM (e.g. A trader bought the stock at $115.50 and now finds he is sitting on a $4.5 dollar loss with the stock now trading $111.00).
The stock repair strategy was constructed as below:
- Long IWM at $115.50
- Current IWM market price $111.00
- Current B/E $115.50
- Buy 1 Mar $111 Call @ $2.65
- Sell 2 Mar $113 Calls @ $1.65
- Collect net credit $0.65 cents
Two potential covered calls to consider would be selling the $113 call at $1.65 or the $115 call at $0.85.
The advantages of the Stock Repair strategy would be the B/E of the entire position will likely be lower than straight selling a covered call. The advantage to the covered call is if the stock recovers and your stock is called away you may actually make a bit more positive return overall. (if you use the $115 call).
|B/E||Max Profit Potential||Max Risk|
|Stock Repair||$112.93||Above $113 = 0.15||At 0 = ($114.85)|
|CC using 115 strike||$114.65||Above $115 = 0.35||At 0 = ($114.65)|
|CC using 113 strike||N/A||Above $113 = Loss (0.85)||At 0 = ($113.85)|
However the main difference to the two strategies is more psychological.
The main advantage to the Stock Repair over the covered call is as follows:
- You are holding a losing position presumably because you still believe in the possible appreciation of the stock.
If you didn’t believe in the stock anymore hopefully you would have the discipline to simply sell out the position at a loss.
If you simply now sell a covered call you are reducing your Delta exposure to the stock immediately.
- Remember you have presumed stock appreciation, the delta of the call you are selling reduces the exposure to price appreciation.
- You are selling this call at a depressed premium for the option due to the stock having fallen in price.
- As the stock does recover the call you sold theoretically will increase in price making the timing of your sale of the call sub-optimal.
With the Stock Repair Strategy the action you are taking at this stock price and time is actually increasing you exposure to the stock.
- Again anticipated to move higher, you are exposed without increasing your financial risk to a move lower in the stock price.
- By employing the Stock Repair the slope of profitability (more accurately a reduction of losses) is immediately steeper than that of the covered call. You are doing something proactive to better your situation.
To me this is psychologically better than reducing your exposure at a lower price or worse, sitting, waiting and hoping that the stock price recovers.
- This higher slope comes at the expense of any significant profits higher in the stock’s price.
The covered call strategy would flatten the slope of profitability immediately
- But it could potentially allow you to profit* if the stock moves higher in a sustained fashion.
*Profit is only possible if you pick a high enough call and the stock recovers.
I hope this clarifies the differences.
1The information in this example is provided solely for general education and information purposes. Any strategies discussed, including examples using actual securities and price data, are strictly for illustrative and educational purposes. In order to simplify the computations, commissions and other transaction costs have not been included in the examples used in this example. Such costs will impact the outcome of the stock and options transactions and should be considered. Multiple leg strategies involve multiple commission charges. Investors should consult their tax advisor about any potential tax consequences. No statement within the example should be construed as a recommendation to buy or sell a security or to provide investment advice.
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