Just came across an interesting webinar to be hosted by IB and presented by CBOE, titled “The Stock Repair Trade” (link here).
It basically introduces a strategy where you use options to lower your break-even price by collecting premium selling near out-of-the-money calls (i.e. giving up the upside). By doing so, you give up your upside but do not increase your downside (compared to doubling down). You can get a copy of the webinar slides by going to the link.
The example given was that you bought 100 shares of XYZ @ $70, it dropped to $60. So to repair to trade, you Buy 1 XYZ $60 Call at $3.50, Sell 2 XYZ $65 Calls at $1.75 each, net options cost is $0 (of course it is not always the case that the outlay matches exactly with the premiums). If you look at the payoff diagram, you will see that your effective break-even price has dropped to $65, but you are giving up all your upside so you will not make money on the trade even if the stock recovers.
To understand how that works, a way to think about this is
- When you sell one $65 Call, you sold off the upside value of your long stock position above $65. In return you get option premium to lower your average cost.
- The $60 Call averages down your position, and you match that by selling the other $65 Call to give away any upside beyond $65. Hence your upside from the averaging down is limited to the stock moving from $60 to $65.
- Both of the above helps to bring the break-even point down to $65.
This is a good strategy if you are looking for the stock to bounce and you take that opportunity to get out at break-even. If the stock doesn’t bounce however, the strategy doesn’t help to limit the damage.
The other two strategies that are compared are
- Hold and hope – Keep your upside if the stock recovers, but will still have a loss even if the stock bounced, since break-even level is higher.
- Double down – Greater upside and greater downside, essentially doubling your upside in return for doubling your downside as well.
All in all, if you are close to options expiration, and you see a potential bounce, this is not a bad strategy. One other strategy to handle this which was not mentioned, was that if the stock seemed really weak, you might just want to flip your position to short the stock instead!