Monday, June 14, 2010

Stock Repair to the Rescue

To say BP has been beat silly over the last month is quite an understatement to say the least. Trying to pick a bottom in this has been like nailing jello to a tree and serves as yet another example of the futility of bottom fishing. So what about those longer term investors who purchased shares in the $50 range and find themselves way underwater? While my first inclination is to question their sanity for allowing a position to drop 50% without jumping ship, let's see if we can lend a helping hand by outlining a stock repair strategy suggested by the Options Action gang on Friday.

Most traditional investors wanting to remain long BP in an attempt to recoup losses really only have two choices. First, they could hold on and hope BP rises back north of $50 - a scenario I find highly unlikely anytime soon. Second, they could double down by purchasing more shares at current levels. The advantage of doubling down is dropping their average cost basis (break-even) to the low 40's. While it is smart to attempt lowering the break-even to increase your probability of recouping loss, doubling your risk at the same time can be a tough pill to swallow. Wouldn't it be nice to lower the break-even without adding risk? Look no further than the stock repair strategy.

This repair strategy can be entered by simply adding a 1x2 call ratio spread to your long stock position. You can think of it as selling a covered call and buying a call spread simultaneously. Suppose our original purchase price of BP was $50 giving us the following risk graph:
[Source: MachTrader]

We have a current unrealized loss of $1900 and need a $19 rise to reach our break-even point.

To enter a repair strategy we could buy one Oct. 36 call for $4.30 while selling two Oct. 41 calls for $2.25 apiece. We're essentially selling an Oct. 41 covered call and buying an Oct. 36-41 call spread. Because the credit received from selling the two 41 calls was sufficient to pay for the long 36 call, this repair strategy can be entered at no additional out of pocket cost. Now let's see if it improved our break-even by assessing the new risk graph:

In the new position, we now only need a rise to $41 instead of $50 to recoup the loss. Though it is ideal to recoup the entire loss, this specific repair falls $280 short. But, let's be honest. Any trader in their right mind would love to turn a $1900 loss into $280. Keep in mind this strategy does nothing to decreasing remaining downside risk, so it's not really a hedging strategy as much as it is a repair helping you make money back quicker.

For a more detailed look at the stock repair strategy, CBOE has a solid write up than can be found here.



Excellent post on stock repair.

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