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This is a level 1 question.
I have been holding a stock that has lost 20 percent in value. It seems to make sense to sell at this point as at the point of buying it I did not hedge the shares! However, instead of selling it and taking an outright 20-percent loss, would it make sense to write a call at its lowest strike price giving a premium that is equivalent to the selling price? Or are there any other alternatives?
As with all options strategies, it all depends on your outlook for the stock. If you think the stock is headed south, selling it and swallowing the loss may be your best bet. If you wanted to try to recover something out of the loss, you could then buy a put and profit from any further downside.
On the other hand, if you feel that the stock has bottomed and is due for a strong recovery, you could double up (buying more shares). This would lower your overall breakeven point on the entire position. The problem is that this requires significant additional capital that is at risk should the stock decline further.
Jim Bittman, senior instructor at the Options Institute, proposes another alternative in his book, Options for the Stock Investor. If you expect the stock to partially recover and are looking to get out at breakeven, there is a method he calls a "stock-repair strategy" that usually requires no additional capital and no increased risk.
Let's say you bought the stock at 50 and it dropped 20 percent to 40. Furthermore, you expect the stock to recover somewhat to 45. The stock-repair strategy could be employed by continuing to hold the shares, and buy a 90-day 40-strike call at 3 and sell two 90-day 45-strike calls for 1-1/2 each. The net cost for this strategy is zero, as the cost of the 40 call is offset by the premium received from the two 45 calls. Also, the short calls are both covered, one by the purchased call and the other by the shares.
If the stock declines below 40, all calls expire worthless and the strategy provides no net benefit or detriment. If the stock ends up between 40 and 45, the sold calls will expire worthless, but the purchased call will have value that will lower the overall loss on a point-for-point basis above a stock price of 40. If the stock moves above 45, the two short calls will likely be exercised. In this case, you would exercise your call and sell your shares to cover. The end result would be a breakeven for the entire trade, since your purchased call would gain back the five points that the shares lost.
The net effect of this strategy is to lower the breakeven point from 50, the level at which the stock was purchased, to 45. While this is the same result as doubling up, there is much less capital at risk with the repair strategy. On the other hand, doubling up allows you to participate in a rally above 45. The repair strategy's maximum result is breakeven, as the sold calls will increase in value at the same rate as the purchased call and the shares above 45. Keep in mind that no one strategy is better than any other. It's all up to where you think the stock will go and how much additional capital and risk you're willing to take on.
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Question Level Key
Level One--Basic Jargon, Definitions, Basic Mechanics of Trading.
Level Two--Introductory Points, Practical Points and Simple Strategies
Level Three--More Advanced Strategies and Repairs
Level Four--Risk Management, Psychology, and How Best to Evaluate Things.
Level Five--High end questions concerning Portfolio Analysis, Managing a Portfolio
of Options, Option Pricing Models, and Nuances of Trading. Included could be a variety of
other topics.
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