Selling covered call and cash-secured put options are used to generate cash flow. Our knowledge of these options can also be applied to mitigating losses after a stock we own declines in value. This article highlights how options can be used to reduce losses in “stock only” portfolios. Although this article was scheduled to be published several months from now, I thought it appropriate to move it to the front of the queue given the recent decline in the stock market.
When to consider the stock repair strategy
- Shares were purchased at a price significantly higher than current market value
- Breakeven is an acceptable target
- Not willing to add additional cash to the position
- Not willing to add any additional downside risk
How to structure the stock repair strategy
- Let’s say we buy 100 shares of BCI at $60.00 and a few weeks later the stock is trading at $50.00
- Buy 1 x $50.00 call for $4.00 (buy 1 at-the-money call)
- Sell 2 x $55.00 calls for $2.00 (sell 2 out-of-the-money calls between current market value and original share purchase price)
- Net option credit or debit should be near $0.00, in this case it is $0.00
Stock price continues to fall below $50.00
Both options expire out-of-the-money and worthless. Since the options did not cost us anything, the option strategy had no impact on the outcome either way and we continue to lose on the stock side. Our position continues to have more risk but no additional risk due to the option positions.
Stock price stays at $50.00
Similar to the above scenario, the options expire worthless and the option positions had no impact on the ultimate outcome.
Stock price moves up to the $55.00 strike
There is a $5.00 loss on the stock side ($60.00 – $55.00) and the $50.00 long call has an intrinsic value of +$5.00, resulting in a breakeven outcome. Notice that by initiating the stock repair strategy, we are lowering our breakeven from $60.00 to $55.00.
Stock prices rises to $60.00 at expiration
The long call $50.00 is worth $10.00 and the 2 short calls have a net debit of $10.00 (-$5.00 x 2) for a total value of zero. Since the stock was purchased and currently is worth $60.00, we find ourselves also at a breakeven situation. This will remain the case no matter how high share price moves so we are giving up upside profits.
Option chain example using American Express (NYSE:AXP)
If AXP was purchased at $79.00 but is currently trading at $75.00, we would look to buy an at-the-money $75.00 and fund it with 2 out-of-the-money short calls. In this scenario, we would buy the $75.00 call for $2.45 and sell 2 $77.50 calls for $2.44 ($1.22 x 2).
Advantages of the stock repair strategy
- Creates an opportunity to recover losses by lowering our breakeven
- Does not require additional cash as would doubling down (dollar-cost-average down by buying more shares at a lower price)
- No additional downside risk
Disadvantages of the stock repair strategy
- Downside risk remains unchanged; continued share decline results in additional loss
- Upside is now capped
- As with all positions, management may be required
Our knowledge of call and put options can be applied to other strategies. The stock repair strategy involves buying 1 at-the-money call option which is funded by selling 2 out-of-the-money call options. This will then lower our breakeven, facilitating opportunities to recover unrealized share price losses.
***The BCI team will be producing a full webinar regarding this strategy for premium members and will also be creating a Stock Repair Calculator. Here is a sneak preview:
AAII National Investor Conference: Las Vegas Nevada
October 26 @ 8:00 am – October 28 @ 1:00 pm
October 26th – 28th, 2018 (Friday through Sunday)
Alan’s presentations: Saturday October 27th at 9:30 AM and 1 PM
Visit Alan, Barry and the BCI team in the exhibit hall Friday, Saturday and Sunday
New York City: March 10, 2019
Philadelphia: September 2019
Details to follow
Online discount broker file updated
This week’s economic news of importance:
- IMF World Economic Outlook 2019 3.7% (3.9% last)
- NIFB small business index 107.9 (108.8 last)
- Producer price index September 0.2% (as expected)
- Wholesale inventories August 1.0% (0.6% last)
- Weekly jobless claims 10/6 214,000 (205,000 expected)
- Consumer price index September 0.1% (0.2% expected)
THE WEEK AHEAD
Mon October 15th
- Retail sales September
- Business inventories August
Tue October 16th
- Industrial production September
- Home builders’ index October
Wed October 17th
- Housing starts September
- Building permits September
- FOMC minutes
Thu October 18th
- Weekly jobless claims 10/13
- Philly Fed manufacturing October
- Leading economic indicators September
Fri October 19th
- Existing home sales September
For the week, the S&P 500 moved down by 4.10%% for a year-to-date return of 3.50%
IBD: Market in correction
GMI: 0/6- Bearish signal since market close of October 8, 2018
BCI: An extremely volatile and down week has made decisions for the November contracts unclear a week prior to expiration of the October contracts. The trade war with China, tariffs and a rising interest rate environment has combined for a nervous, irrational stock market, hopefully short-term. Friday’s action was encouraging. This past week was a perfect example of where “hitting a double” opportunities must be explored. The VIX popped above 20, the first time since April 2nd and only the 3rd time in the past year. Each previous time, the market recovered and the VIX declined. Earnings season results, the Fed re-thinking another rate hike this year and calming of trade war rhetoric with China are factors that can lead to a re-establishment of the bull market.
WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US
The 6-month charts point to a neutral-to- bearish tone. In the past six months, the S&P 500 was up 5% while the VIX (21.31) moved up by 22%.
Wishing you much success,
Alan and the BCI team