Stock Repair Strategy Using Options

The coronavirus crisis seemed to come out of nowhere. It caught retail and professional investors off guard equally. Almost overnight many stocks fell by more than 25%, and although some have managed to recoup their losses over the past few months, many have not.

What is an investor to do in such an environment? One could simply hold on to a stock and hope that it recaptures the lost value. There is nothing wrong with this strategy since, over the long run, stocks generally do rise.

An alternative is to add to the position, lowering the cost base and making it such that the stock does not need to rally all the way back to the original price for the position to break even. The problem with this strategy is that it increases the risk, and if the investor is wrong in timing the bottom, the consequences can be disastrous.

However, there is an interesting technique that can improve the cost base without exposing the investor to added risk: the stock repair strategy.

How does it work?

Consider the example of an investor who purchased Manulife Financial at $26.00 in late 2019.  Unfortunately, the coronavirus crisis caused the price of Manulife to plummet from $27.78 in early February 2020 all the way down to $12.58 in March. The stock has since rallied, but unfortunately it is still trading at only $19.04, which is well below the investor’s $26.00 cost base.

Chart 1: Manulife Financial (MFC) 2019-2020

 Source: Bloomberg

To execute the stock repair strategy, the investor purchases a 1:2 ratio call spread,  buying one at-the-money call while simultaneously shorting two out-of-the-money calls.

Consider an example using the prices from July 20, 2020. In this case, for every 100 shares of MFC stock the investor buys one contract of the October 16, 2020 call with a strike of $19, for $1.00. At the same time, the investor shorts two contracts of the October 16, 2020 call with a strike of $20, for $0.50.

Here is the profit and loss for the position, charting various points in time:

Chart 2: MFC stock repair strategy, profit and loss over time

 Source: Bloomberg

At expiration, if the stock is below $19.00 then there will be no difference in the profit and loss, since all the calls will expire worthless and the investor is in the same situation as if he or she had not traded any options.

If the stock is between $19.00 and $20.00, then the $19.00-strike call has intrinsic value and the $20.00-strike calls expire worthless. This results in pure profit for the investor, improving the cost base of his or her shares.

If the stock is above $20, then all the options have intrinsic value. Using an expiration of $20.75, we see that the $19.00-strike call option is worth $1.75 and the $20.00-strike call options are worth $0.75. The investor will be covered on one of the short calls with the $19.00 strike, but will be forced to buy back the second one to ensure that the original stock position is kept intact. The cost base of the position will be improved by $1.00, but the upside beyond $20.00 will be limited, as the second call will have resulted in a sale at $20.00.

The green line in the above graph represents the pay-off at expiration. The profit improvement is limited at $20, but from there once the options expire, the investor can engage in another stock repair strategy leg to try to improve the cost base again with a new strike and expiration.

The stock repair strategy is an interesting technique to help improve your cost base after a steep decline. This strategy can be much more attractive than adding to the position, because the stock repair strategy decreases risk instead of increasing it. Oftentimes this is exactly the sort of strategy that is needed after a large loss that has taken an emotional toll.

Disclaimer:

The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.