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Stock Repair (Covered Ratio Spread)

Originally bullish and long shares, the investor is now looking to recover some or all of the original investment prior to exiting the long stock position as share prices have declined. 

Outlook & Motivation:    

Originally bullish and long shares, the investor is now looking to recover some or all of the original investment prior to exiting the long stock position as share prices have declined.  With a forecast of a partial rebound over the next ninety days, and not willing to buy additional shares or invest additional cash, the investor decides to employ a Stock Repair strategy. While the options trade must be done in a margin account, if the trade is done for even money or a credit, no additional cash equity is required.

Position Description & Example:

Investor owns 100 shares at $45.00 per share, it has since declined to $35.00 per share, or about 20%.  This is a combination of two bullish strategies; the Covered Call and a Bull Call Spread.

Example Position
Own 100 shares Long 100 Shares @ $45/share
Buy 1 at-the-money call Long 1 90-day $35 call
Sell 2 calls with higher strike Short 2 90-day $40 calls


Position Summary: 

When selecting strikes for the Stock Repair Strategy, the increment between strike prices should represent about one half of stock loss.  To determine how many option contracts, the options purchased should represent the equivalent number of shares originally purchased.  A standard option contract typically controls 100 shares of stock, so one contract for every 100 shares owned.  Ideally, the OTM calls sold would have a premium of about half the price of the purchased ATM options. As such, selling twice the amount of out of the money options covers the cost of buying the at the money option so the stock repair strategy costs next to nothing.  Using longer dated options can often produce a net credit.

Variations:

The Covered Ratio Call Spread could be established as a single bullish strategy by simultaneously pairing a moderately bullish strategy Buy Write (buy stock, sell call) with a directional Bull Call Spread.

Maximum Loss:

Maximum loss is the original purchase price of the stock.  There is risk in continued ownership of the stock in a declining market.

Maximum Gain:

While a profit is possible, the objective of this strategy is to recover most (or all) of the original investment.

Breakeven:

The objective of this strategy is to recover most or all of original investment by reducing the long stock breakeven point.  In this example, the Break Even Point is with the stock at $40.00 on expiration compared to original $45.00 per share.

Volatility:

Somewhat neutral, at the money options are typically the most sensitive to changes in volatility.

Time Decay:

Typically helps the position, at expiration, options will only have intrinsic value.

Assignment Risk:

Although most option holders and writers close out their options positions by an offsetting closing transaction, spread traders should nonetheless be familiar with the rules and procedures applicable to exercise and assignment.  An options writer needs to understand exercise procedures because of the possibility of being assigned an exercise.  For many spread traders, the risk of assignment of an at-the-money or just out-of-the-money option in a ‘physical delivery’ contract is the rationale for closing out spread positions prior to expiration.   

Call writers should also take note of when ordinary dividends are paid.  A call writer’s chances of being assigned an exercise may increase as the ex-date for a dividend on the underlying security approaches.  Early assignment, while possible at any time, generally occurs only when the stock goes ex-dividend. Be forewarned, using the long call to cover the short call assignment will require establishing a short stock position for one business day, due to the delay in assignment notification. In the money options are usually exercised at expiration.

Stock and Option Profit (Loss) Price Chart at Expiration

Stock Price at Expiration

Long 100 Shares

@ $45.00

Long 1 90-day

$35 call @ $5.00

Short 2 90-day

$40 calls @ $2.50 ea.

Net Profit (Loss) at Expiration

$45.00

 $0.00-

+$5.00

-$5.00

   $0.00

$44.00

-$1.00

+$4.00

-$3.00

   $0.00

$43.00

-$2.00

+$3.00

 -$1.00

   $0.00

$42.00

-$3.00

+$2.00

+$1.00

   $0.00

$41.00

-$4.00

+$1.00

+$3.00

   $0.00

$40.00

-$5.00

  $0.00

+$5.00

   $0.00

$39.00

-$6.00

 -$1.00

+$5.00

  -$2.00

$38.00

-$7.00

 -$2.00

+$5.00

  -$4.00

$37.00

-$8.00

 -$3.00

+$5.00

  -$6.00

$36.00

-$9.00

 -$4.00

+$5.00

  -$8.00

$35.00

-$10.00

 -$5.00

+$5.00

 -$10.00

$34.00

-$11.00

 -$5.00

+$5.00

 -$11.00

$33.00

-$12.00

 -$5.00

+$5.00

 -$12.00

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Options at Expiration Scenarios:

All Options are In-the-Money at Expiration:

Shares close above $40.00 per shareLong one $35 call option is in-the-money, and the short two $40 call options also expire in the money.

Resulting position if underlying closes above $40 Call strike price: Provided all option positions are exercised and assigned, there would no longer be stock or option positions, and the trader has recovered original investment. Investors should determine from their brokerage firm the rules and procedures applicable to exercise, and the consequences of submitting exercise instructions. 

All Options are Out-of-the-Money at Expiration:

Shares close below $35 per share.  Resulting position if all options expire worthless and unexercised; investor owns 100 shares of stock at original purchase price.  Loss is based on difference between purchase price of stock and current market value. 

Long Option In-the-Money, Short Options Out-of-the-Money at Expiration

Shares close in between call strike prices of $35 and $40.  If the investor were to exercise the in-the-money $35 call it would require an additional $3,500 ($35 x 100) in cash to purchase 100 more shares of the stock, which was not original objective.  If no options market action is taken, the investor will now have two hundred shares, and twice the amount of market risk

The out-of-the-money $40 call options would typically expire worthless and unexercised.

Investors should be familiar with the rules and procedures applicable to exercise, and the consequences of submitting exercise instructions.   

Expiration Risk:

An option that expires unexercised becomes worthless.  An option holder who intends to exercise an option before expiration must give exercise instructions to his brokerage firm before the firm’s cut-off time for accepting exercise instructions on the last trading day before expiration.  Investors should be aware of their brokerage firm’s policies in this regard. 

Many brokerage firms accept standing instructions to exercise, or have procedures for the exercise of, every option which is in the money by a specified amount at expiration.  Investors should determine from their brokerage firm the applicable cut-off times, the firm’s procedures for submitting exercise instructions, and whether any of their options are subject to automatic exercise.  Investors should also determine whether the exercise of their options is subject to standing instructions of their brokerage firm, and, if so, they should discuss with the firm the potential consequences of such instructions.

Related Position:

The Covered Ratio Call Spread can be established as a single bullish strategy by simultaneously pairing a moderately bullish strategy Buy Write (buy stock, sell call) with a directional Bull Call Spread.

Opposite Position: NA

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