The following strategy uses options to help an investor regain losses absorbed in their equity portfolio. Whether the market is in bull-market or bear-market territory, every investor will inevitably suffer some upsetting portfolio losses at some point in their trading career. However, with proper discipline, there is a way to recover from these negative returns, even if the stock never bounces back to its original purchase price.
An investor’s first step in such situations is to determine their forecast. In other words, review your original analysis of the stock and decide whether your rationale for entering the trade is still intact.
- If you conclude that your original analysis was incorrect and the stock is not showing any potential for future recovery, the best bet is simply to sell the stock, take the loss, and move on to the next opportunity.
- However, if you are convinced that your analysis of the equity was correct, albeit a bit premature, you could commit additional capital and acquire more shares at a reduced price compared to the original purchase price. This strategy is known as "averaging down," or "doubling-up."
Be extremely cautious of this doubling-up strategy. In addition to committing additional capital to a losing position, you now have a larger portion of your portfolio devoted to a losing trade. Should your bullish hunch on the shares prove incorrect, this could turn a modest loss into a devastating blow to your trading capital. In a nutshell, this strategy puts a greater percentage of your portfolio at risk.
- Finally, there are those looking for only a modest rebound in the stock, thereby allowing them to exit the position near the break-even mark. If your goal has changed from achieving profits to merely recovering your initial investment, the stock-repair strategy could be beneficial.
In contrast to the “doubling-up” strategy, the stock-repair strategy does not involve the commitment of additional capital or the assumption of additional risk.
Let’s go through an example to illustrate how this strategy works.
Feeling optimistic about stock ABC, Sue purchased 100 shares at 60. Things do not go as hoped, however, and the equity declines to 50. While not as overtly bullish as when Sue opened the position, she believes the stock can advance back to the 55 mark within 2 months, effectively splitting the difference between its present level and the original purchase price. Rather than take an expected loss of 5 points, she will use options to get back to breakeven in a way that won’t require more capital or added risk.
How does this work? She will buy 1 at-the-money 50 call at a cost of 5 and sell 2 out-of-the-money 55 calls for 2.50 per contract. All options should expire in about 2 months, or roughly the time period during which she expects the stock to recover back to 55. Sue continues to hold her 100 shares. The net cost of the strategy consists only of commissions, since the premium received from the 2 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 3 possible outcomes for this strategy at option 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 calls would expire worthless, but the purchased 50 call would have value, thereby mitigating some of the loss on the stock.
Third, if ABC rallied above 55, the calls she sold would probably be exercised, and she would have to deliver 200 ABC shares. This would be covered by selling the 100 shares she owns at 55 (a five-point loss), plus exercising the 50 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 had she doubled up on the stock. However, there was no net influx of capital required to achieve this lower break-even point. The trade-off for this benefit is that, unlike doubling up, Sue was unable to participate in any additional upside beyond 55. The best she can hope for is to break even. This underscores the importance of matching the strategy to expectations for the underlying stock.
