Online Stockmarket Trading Update

Part 4: The Stock Repair Strategy

The Stock Repair Strategy is the options trading strategy designed to “repair” a stock account that has suffered from capital loss due to a drop in price.

This strategy allows the loss to be recovered with a moderate rise in the price of that stock. For example, if you bought shares of AAA company and it has dropped significantly since you bought it, say 10%, you could use the Stock Repair Strategy to recover that 10% loss as long as AAA company stock rises about 5%. I’m sure “buy and hold” investors would have a number of likely candidates for this strategy in their portfolios.

The Stock Repair Strategy - is designed to use stock options, with limited risk, to quickly recover the loss from a drop in the share price.

Use the Stock Repair Strategy to recover losses in your stock position when that stock is expected to rise moderately. If you are of the opinion that the sell-off in a stock has finished and the stock is likely to bounce from current levels, then the Stock Repair Strategy can help you “repair” a stock account which has suffered from capital loss due to a drop in price, in double quick time.

The Stock Repair Strategy is achieved through buying 1 contract of at the money (ATM) call options for every 100 shares you own and then writing twice as many out of the money (OTM) call options at a strike price where the total proceeds cover (or nearly cover) the amount spent on the at the money (ATM) call options.
Therefore the Stock Repair Strategy does not cost anything to put on (apart from transaction fees of course) and requires no margin. This makes this strategy ideal for anyone who expects the stock price to recover near term and wishes to quickly recover losses sustained in a stock position.

Traders can use this strategy to double up their position with minimal risk and minimal cost. However any gains are capped to the upside at breakeven, so that you would exit the original position flat, and you do not get any protection on the downside. Having this position in place is an excellent way to quickly recuperate stock losses at no extra cost, if the stock rallies all the way to the strike price of the short call options.

Advantages and Disadvantages

The Stock Repair Strategy has its advantages as it can bring your stock position back up to breakeven, so as long as stock rises moderately. There are minimal costs to place the position and it requires no margin.
However it has the disadvantage of cutting profits at breakeven, so that no further profits can be obtained if the stock rallies beyond the strike price of the short OTM calls.

Example Trade – ANZ Bank

ANZ traded between $21.00 and $22.00 for over a month through to mid-June, and was trading on a grossed up yield of over 9 percent. If you had purchased the ANZ stock on a breakout you could be holding the stock at a cost of around $22.05. There have been some wild gyrations over the subsequent months, but for those “buy and hold” investors there is still hope: utilise the Stock Repair Strategy to recover losses in your stock when that stock is expected to rise moderately near-term.

The stock repair trade for ANZ was priced on September 7th 2011 when the October options had 48 days until expiry and ANZ shares were trading at $20.10.

Trade Details:
Buy 1 contract of at the money (ATM) 2000 Oct11 call options (for $0.96/contract) for every 100 shares you own and then write (sell) 2 of the 2100 OCT11 out of the money (OTM) call options (at $0.46/contract) for every 100 shares you own.

This trade costs 4 cents/contract to place and if you are exercised you will sell youf original share parcel at $22.00 (5 cents shy of the purchase price). Note cost calculations do not include associated transaction costs.

Chart 1: ANZ Stock Repair Trade

You can plan and analyse your trade as shown above, using the Derivative Profiler function in the Market Analyser software.

Trade Note

The Stock Repair strategy simply involves buying 1 contract of at the money (ATM) call options for every 100 shares owned and then writing twice as many out of the money (OTM) call options. The Stock Repair strategy costs next to nothing to put on and if the stock drops further, the ATM calls simply expire with the OTM calls, which completely offset each other, causing no additional losses to your original stock position. This strategy reaches its maximum profit potential when the stock price is equal to or greater than the strike price of the out of the money (OTM) options.

The goal of the ANZ trade is for ANZ to be trading above $21.00 at the October expiry, so that the position is repaired with minimal or no loss. Please note that ANZ is due to go Ex-div around 4 Nov’11 around $0.74 cents per share, so if the stock does not get exercised, then the dividend will offer some comfort.

Using the Stock Repair Strategy, the stock needs only move up by 5% to reach breakeven, however the stock could drop 10% and the position’s loss would be the same as if the Stock Repair Strategy was not implemented.

The Trade

Options can be used in order to reduce your risk while still participating in potential profits from a significant move by the underlying stock. Today we’ve explained the Stock Repair Strategy which allows you to “double down” on your current losing position for minimal cost, however your profits will be restricted to breakeven on the trade. Note this strategy does not offer any protection to the downside.

In future articles we will talk about the High Yield Covered Call strategy and the High Yield Covered Put strategy, which is particularly relevant to this market.

Utilise the features in the Market Analyser software to trade plan your options trades for the particular options strategy using your specific trade selection criteria. You will save time and potentially reduce your trading risk.

By Michael Hevern
Head of Research

See Also:
Options Trading for All Types of Market Environments (Part 1): The Protective Put
Options Trading for All Types of Market Environments (Part 2):The Covered Call
Options Trading for All Types of Market Environments (Part 3):The Covered Call Collar

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