There are three possible outcomes for this strategy
How many times have you suffered a loss on a stock position and wished the stock would bounce back to the original price so you could get out at breakeven? There is a method -- often called the "stock repair strategy" -- that can help regain some (or all) of the losses on a position by using a combination of buying and selling options.
Before using this approach, however, you need to determine your forecast for the underlying stock. If it isn't showing any signs of future recovery, the best bet is to simply sell the shares, suffer the consequential loss, and move on to the next opportunity.
If, however, you’re convinced that your bullish intuition was correct (but perhaps a bit premature), you might want to acquire more shares at a reduced price. (Be wary of this doubling-up strategy, as you must commit additional capital and are at risk of losing even more money should your bullish hunch prove incorrect). For those who expect the stock to stage a partial recovery and whose goal has changed from achieving profits to just breaking even, the stock-repair strategy might be ideal. Unlike doubling up, this strategy often works without committing additional capital or assuming additional risk.
Let’s illustrate this strategy at work. Feeling optimistic about stock ABC, we purchase 100 shares at $60. Things do not go as hoped, however, and the equity declines to $50. While not as overtly bullish as when we opened the position, we believe the stock can advance back to the $55 mark within two months, effectively splitting the difference between its present level and the original purchase price. Rather than take an expected loss of five points, we will use options to get us back to breakeven in a way that won’t require more capital or added risk.
How does this work? We implement the stock-repair strategy by buying one at-the-money 50-strike call at a cost of $5, or $500 per contract, and selling two out-of-the-money 55-strike calls for $2.50, or $250 per contract. All options should expire in about two months, or roughly the time period during which we expect the stock to recover back to $55. We continue to hold our 100 shares. The net cost of our strategy consists only of commissions, since the premium received from the two sold calls offsets the premium paid for the at-the-money call. Also, note that both of the sold calls are “covered” -- one by the purchased call, and the other by the original 100 shares.
There are three possible outcomes for this strategy at options expiration. First, ABC could continue its losing streak and close at or below the $50 mark. In this case, all of our options (both sold and purchased) expire worthless, thereby having no net effect on the position (other than commissions paid). Second, ABC could finish between $50 and $55. The sold 55-strike calls would expire worthless, but the purchased 50-strike call would have value, thereby mitigating some of our loss on the stock. Third, if ABC rallied above $55, the calls we sold would probably be assigned, and we would have to deliver 200 ABC shares. This would be achieved by selling the 100 shares we own at $55 (a five-point loss), and exercising the 50-strike call to buy 100 shares at $50 and selling them at $55 (a five-point gain) to cover the other sold call. Note that the break-even point is effectively lowered to $55 -- the same result if we had doubled up on the stock. However, there was no net influx of capital required to achieve this lower breakeven point. The trade-off for this benefit is that, unlike doubling up, we are unable to participate in any additional upside beyond $55. The best we can hope for is to break even. This underscores the importance of matching your strategy to your expectations for the underlying stock.