A Stock Trade Gone Wrong

It is a position that all traders have been in, buying shares with the expectation of bullish movement but the trade moves in the adverse direction. No trader wants to cut losses and admit that they are wrong, even if it is the most prudent thing to do in some cases. However, from a psychological perspective, it is only natural to think of ways to get out of the trade at a breakeven price and to mitigate losses. Consider a scenario where a stock is bought at $100 and drops 10% to $90. Traders usually do this using the following methods to try and get out of the trade at the breakeven price or a minimal loss

1. Hold & Wait - by simply holding the stock and hoping that it will rally back to the entry price, the trade can be closed at breakeven. This can take months, even years, and there is no guarantee that the stock will ever reach the breakeven price. 
2. Dollar Cost Average - In the above scenario where the stock moves down to $90, by buying more of the stock at $90, the breakeven price moves lower. This works well if the stock does rally, but also adds more risk as the position size is increased and more money is lost if the stock continues lower. 
3. Sell your Holdings - From a risk perspective, this could be considered as the most prudent strategy. This allows the trader to invest their capital elsewhere and cancel the risk of further losses in the stock. 
4. Stock Repair Strategy - A similar strategy to dollar cost averaging. This strategy improves the breakeven price, adds little or no additional risk, but also caps rewards. The main difference between this strategy and the dollar cost average strategy is that with dollar cost averaging, if the stock moves above the new breakeven, the trader will reap the rewards of the additional risk taken and turn the losing trade into a profitable one. With the stock repair strategy however, the trader will not be able to profit if the trade rallies above the breakeven price. 

Stock Repair Strategy

Consider the example where a trader owns 100 shares of XYZ stock at $100. The stock drops 10% to $90. To use the stock repair strategy, a minimum of 100 shares must be owned. The stock repair strategy involves selling a call ratio spread (selling 2 call options and buying 1 call option). Another way to view this is:

• Sell covered call at breakeven price
• Buy a call debit spread (buying 1 ATM call and selling 1 OTM call)
• The goal of this is that the proceeds from selling the covered call will pay for the cost of the debit spread resulting in a "free" debit spread. However, this may not always be the case and the trader may have to pay a small amount or even receive a small credit from the call ratio spread. This strategy should not be adding any additional risk to your portfolio or reducing any risk to your portfolio. 

Example:

Own 100 shares of stock XYZ @ $100. XYZ is currently trading at $90:

• Buy 1 $90 call option at $3.00
• Sell 2 $100 call options at $1.50

Another way to look at this:

• Sell 1 covered call @ $1.50
• Buy a call vertical spread some text
  • Buy 1 $90 call @ $3.00
  • Sell 1 $100 call @ 1.50

This results in a net debit of $0 as the premium received from the covered call offsets the cost of the debit spread and therefore no additional risk is taken on this trade. As shown in the diagram below, this strategy will not result in any profits if the stock were to rally past $100 but does result in a lower breakeven. 

The new breakeven price is calculated by averaging the breakeven price of the covered call and call debit spread:

• Covered call breakeven: $100 - $1.50 = $98.5 
• Call debit breakeven: $90 + $1.50 = $91.5 
• New Breakeven = $95

Stock Trade vs Repair Trade 

As shown in the table below, at expiration, the stock repair trade does not provide downside protection but does offer a better breakeven price ($95) while capping profits once the stock moves above $110 ($10 maximum profit). 

Repair Strategy Factors

• Requires 100 shares (as a covered call will be sold)
• Must still have a bullish outlook on the stock - the repair strategy requires some bullish movement to breakeven)
• Not suitable for a sharp rally - Because this strategy involves selling 2 options, time decay works in the favor of this strategy. The stock repair strategy should only be used when a moderate bullish move is expected, and the stock reaches the breakeven price close to expiration. 
• Does not provide downside protection
• Generally, not suitable for trades greater than a 5%-7% loss
• Works better in higher volatility environments
• Does not provide any downside protection