There is nothing worse than making a new purchase of a stock and then watching the stock quickly move down.
Fortunately, we can use options to speed up the recovery process for stocks that have fallen. The strategy we’re going to look at today is called a stock repair strategy.
The idea of this strategy is that the investor can reduce the price to breakeven without adding more capital to the trade. There is no additional downside risk when trading.
Let’s look at an example using a stock that has been under pressure in recent months — Microsoft (MSFT).
Microsoft shares in a downtrend
Assuming the trader was lucky enough to buy Microsoft stock at 280, he or she would be at a significant loss. Shares closed at 244.74 on Friday.
As a stock trader, you would need the stock to recover to 280 to return to profitability.
However, by using options, we can reduce the equilibrium price to 260 without adding additional risk to the trade.
Here’s how it can be done:
Buy 1 February 245 call at 21.60
Sell Feb 2 260 calls at 14.35
Buying 245 calls costs $2,160 and selling two of 265 calls gets a $2,870 credit. The net result of making the trade is a credit of $710.
No additional risk for merchants
Since the trade is made for credit, there is no additional downside risk. If Microsoft stock stays below 245, the call options expire worthless and the trader still owns the 100 shares of the stock.
The equilibrium price is also reduced to 259.
If the stock ends up between 245 and 260, the combined stock recovery strategy will outperform the pure stock position.
The trade-off is that any potential profits above 260 are lost.
Today you learned that a stock correction strategy is perfect for an investor holding a losing stock who just wants to get back to profitability and exit.
This can help the investor reduce their cost of profitability with little or no cost.
No additional loss protection
The strategy does not protect the investor from a further decline, but it may be a more attractive proposition than “doubling up”.
When using the stock recovery strategy, the investor is giving up any potential upside in the stock.
Please remember that options are risky and investors can lose 100% of their investment.
This article is for educational purposes only and not a commercial recommendation. Remember to always do your own due diligence and consult with your financial advisor before making any investment decisions.
Gavin McMaster has an MA in Applied Finance and Investments. He specializes in income trading using options, is very conservative in his style and believes that patience in waiting for the best setups is the key to successful trading. Follow him on Twitter at @OptiontradinIQ
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