Investor's Business Daily, March 12th, 2007
Much like their stock trading brethren, option strategists that have succeeded over time know how important reducing open risk is, while showing a profit on paper. Equally as important, both groups also know how imperative it is to manage our losses effectively, so they don't spiral out of control. One way in which the limited risk options trader can sometimes circumnavigate this necessity is by converting the original position into a repair strategy.
Like its name suggests, the repair strategy is used to fix a problem in the form of an options position turned somewhat ugly on paper. The most common situation and easy to understand version of this adjustment procedure is after a trader purchases a Long Call. At some later date and for whatever reason, the initial position has lost value, most likely related to an adverse (i.e. lower prices) move in the stock.
The typical reaction for a trader looking to keep their losses contained would be to exit the Long Call for a loss. However, there are certain situations, less likely mind you, that sometimes the position can be converted into a repair strategy for no additional cost while reducing the stock price needed to breakeven. The best way to understand the repair strategy is with a dummied down and generous pricing version of this two step process.
Let's say a trader has purchased the at-the-money XYZ 70 Call for a $2.00 debit. Several days later the stock gaps down to $66-a-share. Simultaneously, the Calls are trading for a debit of $1.00. The typical response at that time might be to simply sell out or close the Calls for a loss of -$1.00 per contract. But, let's say the Calls on the 65 Strike are changing hands for a $2.00 debit. If this was the case and one was willing to make the choice of adjusting, a trader could attempt to repair the original position by adjusting into a Long Bull Call spread.
With the prices shown, this could be executed for even money. For simplicity's sake, using one contract, the strategist would buy the 65 Call for a $2 debit and sell 2 of the 70's (one opening contract, one closing contract) at $1 each, which nets out to even money. This means the trader would be transferring the risk of a Long Call into a Bull Vertical. Does this mean that we're not losing money? Nope. While the repair doesn't cost any additional capital to execute, outside commissions, the reality is that the trader would still be down a $1 debit at that time based on the market price of the 65 / 70 Vertical ($1 debit) versus the $2 debit in effect the position was established for. The reason, however, that the repair could interest some traders is that instead of a $72 breakeven (70 Strike + $2 Initial premium), should the stock rally by expiration, the position would scratch out at $67. In this case, with the stock at $66, a stock rally of one point by expiration might sound a lot more appealing than $72 or using an exiting strategy that results in a bonafide real world loss of $1.00. In effect the trader would be biding time and price as the repair was being made.
Before traders rush out with the idea that technical stops are a thing of the past, a couple of caveats do need to be emphasized. Remember, this example is very generous in its options pricing, considering the move in the underlying. That means if a trader is inattentive to existing positions as they think that a loss can always be worked into something more favorable, they're going to be in for a rude awakening. Secondly, on those less technically severe occasions where this type of repair might be transacted, traders should still approach it sparingly. If used as a crutch for too many misdirected positions, in the end it will inevitably cost us more than the initial price for admittance.
Copyright 2007 Investor's Business Daily, Inc.
The observations provided are not investment advice or a recommendation, the suitability of which is considered the responsibility of the trader. Copyright 2006 through Optionetics, Inc. All rights reserved. Optionetics is a Trademark or a registered Trademark of Optionetics, Inc., in the United States and/or in other countries.
