Recouping Losses with the Repair Strategy

Many investors have purchased a stock, based on solid fundamental and technical research, only to have a government investigation, unannounced CFO departure, CEO assassination or other unpredictable event occur and send shares dramatically lower. The first question on the minds of these long-term investors becomes: “How do I get my money back?”

Well, the very first thing you should do is go back and reassess the stock. If things are going from bad to worse, it is often best to sell the stock and cut your losses. Just think, you can always look forward to your $5 shareholder class action lawsuit payout check in a few years if it was fraud-related! However, if you expect a recovery, there are other options available.

The repair strategy is one of these options – it will allow you to reduce your breakeven point without committing any additional capital. The market may seem unforgiving sometimes, but there is no shortage of options strategies (especially LEAPS strategies) designed to solve your problems! Let’s take a look at the repair strategy and how it can help you…

The Repair Strategy

The repair strategy involves building an options position around an existing stock position in order to lower the breakeven point without committing any additional capital. This is done by purchasing one long call while simultaneously writing two calls for every 100 shares you own. The premiums collected typically more than offset the cost of the call while the 100 shares you own covers the second call written. Meanwhile, the long call’s upside will decrease your breakeven point.

Since that probably seems confusing, let’s take a look at an example:

John purchased 500 shares of Acme Warehousing at $90 just a few weeks ago, but there was a warehouse fire and the stock dropped to $50.75. John knows that insurance will cover the losses and expects the stock to recover over the next few months, but the lost business does lower his expectations and he thinks $90 may be an overly optimistic target.

John is just looking to recover some of his losses quickly so he can reinvest in better opportunities. His mother-in-law suggested purchasing more stock in order to “double down” and reduce his breakeven point, but he listened to her last time and ended up losing more. After all, that would involve committing more money to the position while assuming more downside risk.

Wisely, John decides to use LEAPS in order to dig him out of this hole. Upon checking with his broker, he finds the following 12-month call options:

• 50 Call - $13.10
• 60 Call - $9.60
• 70 Call - $7.10
• 80 Call - $5.20

John decides to purchase 5 of the 50 calls and simultaneously write 10 of the 70 calls. The position can be established for a $550 credit and will enable him to reduce his breakeven point from $90 per share to just $70 per share. It also enables him to reduce any future losses by offsetting it with the $550 credit received. The only downside is that he will lose any upside above $70 per share.

Let’s take a look at this position in detail:

Stock Price	Profit/Loss	Credit/Debit	Value of 50 Call	Value of 70 Call	Value of 70 Call	Net Profit/Loss
$50	-$40	$1.10	$0	$0	$0	-$38.90
$70	$-20	$1.10	$20	$0	$0	$1.10
$90	$0	$1.10	$40	-$20	-$20	$1.10

As you can see, John has effectively reduced his breakeven point to $70, but gave up any upside on the position since his shares and long call options will be called away by the two short call options above $70 per share in a proportional amount. What happened to John? Acme Warehousing rallied to $200 per share a few days later when news surfaced that the fire was a rumor. Sorry, John.

But wait, can John get out of this new mess and realize some more upside?

Getting Greedy (After-the-Fact)

John went from greed to fear and now back to greed – he wants out of this option position now that the fires were just a rumor. Luckily, he may be able to unwind the position to his advantage. Essentially, this means selling off the options he purchased while retaining the underlying stock without losing any money.

Acme Warehousing shares have rallied to $80 per share now that the fires turned out to be a message board rumor (who reads those anyway?). John can still liquidate his total option position and keep a $10 credit while keeping his 500 shares. How? Well, the value of long 50 call is $30 while the value of the two short 70 calls are just $10 each. For those who failed math class, this means that he keeps $30 and has to pay $20, which means a $10 profit on the position.

Unfortunately, John’s wife arrived just as he was about to trade and was furious that he didn’t listen to his mother-in-law. While trying to explain how much better LEAPS are, the stock continued its rally to $100. John now realizes that unwinding the options position will cost him $10, which means that it is equivalent to re-establishing a long position in the stock at the then market price (the $90 for the original stock, plus the $10 cost to close the options position).

Note: Our example is highly simplified. The actual prices of these options will, however, depend on the time left until expiration and the change implied volatility. A greater time until expiration means a higher time premium while higher implied volatility means a higher premium on the options. These may change the values slightly when looking at your options…

Conclusions

In case you were wondering, John ended up letting his shares getting called away and getting out of the situation. The lessons he learned:

1. The LEAPS repair strategy is a great way to reduce your breakeven point at no additional cost!
2. Don’t listen to message board posts or anything that is not backed up with fact!
3. Don’t listen to your mother-in-law!

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