How To Repair A Trade That Has Gone Bad
by C. Talmadge BellAugust 30, 2012 | Comments : 0 Recommended this article: (0)
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A losing stock is part of all investors' experiences. Of course, with a good money management plan the losses will normally be small. However, occasionally there will be a trade that gets away from you. Maybe it was a stock on which you neglected to place a stop. Or, perhaps you had a stop limit order in place, but the stock price gapped past your limit. This article is about what to do when a trade gets away from you. We'll discuss a strategy that is an alternative to just selling the stock at a loss.
More specifically, I am talking about a stock that you believe still has some upward potential and might recover at least partially from your purchase price. However, you feel that the reversal will take a lot longer than you are willing to wait. This might apply to current holders of stock in companies like Office Depot (ODP), Groupon (GRPN), or Dell (DELL). For me, it has to do with a recent trade that I made in VirnetX (VHC).
What kind of a trade can be repaired?
This strategy will work only for a stock that makes at least a partial recovery. You use this when you expect the stock to eventually come back to the price at which it was purchased, but you think that it will take quite a while for that to occur. If the stock price continues to fall or stays flat, then this strategy will not help. However, it does not cost anything and you may even make a slight gain. So, you are not really out anything by applying it, instead of closing the trade at a loss, except for the opportunity cost of not moving on to another trade immediately.
This is a low cost repair strategy. It is often no cost at all or can even have an immediate small credit to your account. It will get you back to break-even sooner than waiting for the stock's price to rise back to your original purchase price. Your stock's price will have to regain only part of its lost value. You will actually be able to get to a break-even point at a price that is significantly lower than your original purchase price. And, it can be applied without increasing your risk since little or no additional funding is required.
This strategy will trade options with usually two or more months remaining before expiration. Most of the time you will notice that the farther out the expiration date is, the more likely it will be that your trade will create an immediate credit.
First you purchase one out-of-the-money Call for each 100 shares of stock that you own. You will then pay for the Call by selling two farther out-of-the-money Calls. All of the Calls will have the same expiration date. Your analysis of which Call to buy and which Calls to sell should evolve around selecting from the available premiums, so that the cost of the one Call that is purchased is covered by the income from the two Calls that are sold.
You should be able to select a pair of strike prices that will give you close to a zero cost for the trade. It is even possible for the income from the two Calls that are sold to exceed the cost of the one Call that is bought, especially if your expiration date for the options is farther out. Thereby, giving you a credit for the trade. Just make sure that the expiration date of the options is far enough in the future to give the stock price time to increase back to the level of the strike price of the two Calls that were sold.
Example Repair Trade
I purchased VirnetX (VHC) on July 10 at $35.75. Within a week it had reached almost $42, but then started to drop a small amount. I was not too concerned as I expected it to continue up in a few days. Besides, I had a stop loss in place. But, on July 24, the price fell from a bit over $35 down to about $27 and had gapped past my stop. In the next two days, it continued to drop to as low as $21.25.
When it got to $25.75, I had enough. By the time that I placed my trade, about mid-day, the price had dropped another $3.00 to $22.75. Does this sound like anything that has ever happened to you?
This is what my choices were:
1) I could sell out at a loss of $13.
2) Or, hold on to the stock until its price rose back to my purchase price of $35.75 and then sell out at break-even.
3) Or, I could initiate the repair strategy that we are going to talk about. This repair strategy will require that I wait only until the stock price reaches $28.
Here is the trade that I initiated:
BUY: One SEP $25 Call for $4.30
SELL: Two SEP $28 Calls for $8.40 ($4.20 each)
Net Credit: $4.10 ($8.40 from the sale of two $28 Calls minus $4.30 for the cost of one $25 Call)
What we have in this trade is one of a number of different option plays that are generally classified as ratio spreads. If you look at it closely you will see that it is a combination of a Covered Call and a Bull Call Spread. The Covered Call is the long stock position and one of the short $28 Calls. And, the Bull Call Spread is the long $25 Call and the other short $28 Call.
How does the repair work?
If VHC is above $28 when the SEP options expire:
1) The shares will be called away and I will receive $28. This will be a $5.25 gain over the $22.75 that my stock was worth when I initiated the repair trade.
2) I have already received a $4.10 credit when I initiated the trade.
3) The $25 Call that I own will have a value of at least $3.00 (since the stock price is at least $28).
This will be a gain of $12.35 per share over the paper loss that I was showing at the time that the repair strategy was initiated. At that time, I was looking at a potential loss of $13.00. Now, I will be out of the position with a small loss of only $0.65 per share.
The most interesting part of this strategy is that I will be getting out of the position at a time when the stock's price is still $7.75 lower than when I purchased it. And, of course, a lot sooner than it would have been if I had decided to wait it out until the stock finally got back to my original break-even point. Also, note that the small debit in this trade could have been a small credit instead, if I would have been willing to wait for the options that expire in October instead of September.
What if the stock does NOT make any upward movement?
As I mentioned earlier, if the company does not recover, this strategy will not help your position. Since the cost is little or nothing, you are not any worse off than you were to start with. If fact, you can structure the trade so that you will actually have received a small credit. In my case, I will have the $4.10 net credit, from the trade of the Calls, to offset the paper loss or any additional loss if the stock price continued to go lower.
If the stock did not recover to the strike price of the short Calls, your choices are to either do as you could have done in the first place close the position at a loss or initiate the same trade again with a farther out expiration date. If you structured the trade to bring you in a credit, then the stock could have even dropped a bit lower and the credit would have lessened the impact of the additional loss. As long as the company doesn't go out of business, you could continue this strategy and each time receive small credits that, over time, help reduce your loss.
You can learn more about different types of option strategies by downloading our free options booklet: 3 Smart Ways to Make Money with Options (Two of Which You Probably Never Heard About). Just click here.
And be sure to check out our Zacks Options Trader.
Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.
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