When Things Go Wrong - Repair Strategy

The Repair Strategy

If, whenever you puchase a stock and it rises, all is well and this post is redundant. On the other hand, like some of us mere mortals, you have purchased stocks that had the audacity to fall in price, this Repair Strategy may be useful.

Let's randomly choose a stock, Citibank, for purpose of illustrating this Repair Strategy.

Supposing, during the recent mini rally, you were convinced that C was poised for better days and hence better prices and purchased 500 shares of C at $7. We know that C settled for less than $3 as of 20Jan09. Ouch !!! This is >50% decline in value of the stock.

Ordinarily, investors who are bent on believing that, maybe in the long long term, C will be priced at a higher value, maybe tempted to add on positions at a lower price; a method described as Dollar Cost Averaging (DCA). There are several disadvantages and flaws to this approach. Namely :

a) By purchasing more of C at a lowered price, represents further capital outlay.
b) The downside risk exposure is also compounded by the amount of shares added on.
c) The initial reasons for going Long C is clearly not working out, so why add on to a trade that is not reaping rewards?

Therefore, it would be more sensible that should an original opinion, translated into some trading/investment positions, is no longer valid, it would be better to accept those losses and move on.

However, life as a I/T is hardly all that straight forward. There are multitude of reasons that people hang on to C even when the investment has devalued by >50%, as is the case in our example. So, let's not dwell into the whys and wherefores of such behaviour. What's done is done and the purpose is therefore to "Repair" a damaged situation.

Since it is a repair technique, it is no longer a "profit oriented" approach, but one that centres around "getting your initial money back". This is an important notion, that one who's adopting this repair strategy will benefit dearly to remember.

Also, it is very critical to understand that this repair method is based on the assumption that C shares will increase in price over time. If the view is that price will continue to drop further, then this is NOT the correct strategy to adopt.

Let's get into the specifics now.

500 shares of C bought at $7
C is now at $3
Call Options..................Premium
Sept 3......................$1.15
Sept 4......................$0.86
Sept 5......................$0.66

Instead of purchasing another 500 shares of C at $3, which will immediate deficit your trading account by another $1500, do this.

Purchase 5 contracts of Sept 3 Call. 5 contracts is equivalent to possessing the right to buy 500 shares of C at $3 anytime until Sep09 expiration. This purchase will cost 500 x $1.15 = $575
Sell 10 Sept 5 Call and receive 1000 x $0.66 = $660
Net result, you receive $85 (660 - 575)premium.

What did you achieve by doing this?

1) You do NOT need to pay out $1500, which is what will cost you if you had purchased outright the additional 500 shares of C at $3
2) You receive $85, to establish Long 5 Sept 3 Call and Short 10 Sept 5 Call. Effectively, no outlay at all. AND you acquired the right to purchase 500 shares of C at $3 anytime from now until Sept09. It means, if you want to, you could exercise your 5 Long Sept 3 Call and buy up 500 shares of C at $3 at anytime before expiration. So, why buy now? Buy only when C has gone up in price. If C doesn't rally, then forget this whole entire trade. It cost you nothing, but in fact, you got paid $85. In my books, there's no better deal than this.

Going forward in time....

C rallies and by Sept09 expiration, price goes above $5. What happens?

a) You exercise your right to purchase 500 shares of C at $3, thereby lowering your cost of C to $5 (1st buy at $7 and 2nd buy at $3. Average = (7+3)/2 = $5)
b) Since C has gone beyond $5, that Short 10 Sept 5 Call, will have become ITM. You will likely get exercised and 1000 shares of C will be called away from you. Perfect !!! You got out of your position at a lowered price of $5, broke even and cost you nothing (except some commissions).

C drops further. Well, you would not be any better off having enacted this "ratio spread" of +5 ATM Call and -10 OTM Call, but neither would you be worst off, if you had just let things be. Restated, you cannot do any worse off using this repair strategy than if you did nothing to your existing 500 shares of Long C.

Making it even plain simple...you have everything to gain and nothing to lose using this Repair Strategy. Compare this to DCA method, which compounds your risks, and cost you more capital outlay.

Finally, I will make a brief point about Volatility. For this Repair Strategy to work, the stock in question must possess a relatively higher Volatility. For stocks that are quiet for most parts of their trading cycle, implying lower Volatility, it may not be possible to obtain +ve net credit when trying to enact the Ratio Spread (eg 5 Long Sep 3 Call and 10 Short Sep 5 Call). If so, this Repair Strategy may require payment upfront. The I/T must then decide if it is meaningful to go down this path.

All men (and women) are created equal in the eyes of God. But not all markets are made equal. Many Asian bourses do not offer american options to retail investors. This greatly inhibits achieving creative profits or mitigation of losses. I don't see why we should not consider trading other exchanges that provide more value for our investment money, other than mere convenience or sheer ignorance.