Objectives Met?

Let’s verify how this strategy helps us meet our outlined objectives. The first, was to reduce our break-even point. The table below gives the value of our overall position, stock and options, at the November expiration. Note that there are 2 columns for the short 35 calls since we wrote 2 of these for every 100 shares that we own.

BBB @ Nov.
Expiration
Value of BBB Value of long
30 Call
Value of short
35 Call
Value of short
35 Call
Total Value
$37.50 37.50 7.50 (2.50) (2.50) 40.00
$35.00 35.00 5.00 0.00 0.00 40.00
$32.50 32.50 2.50 0.00 0.00 35.00
$30.00 30.00 0.00 0.00 0.00 30.00
$27.50 27.50 0.00 0.00 0.00 27.50
All values shown are at the time of expiration .Commissions and other fees not included.

Notice that the total value of the position reaches $40.00 if BBB rallies back to $35. Since our original cost was $40, this means that we have reduced our break-even from our cost of $40 to $35. This is good.

Our second objective was to limit the amount of new capital allocated to this position. In fact, we did not have to commit any new capital to this trade. We purchased 4 calls at a cost of $1,200, but simultaneously wrote 8 calls that brought in the same amount. Cash required: none. Note that quite often this strategy can be initiated for a small debit or a small credit. The small credit is a plus, but a small debit should not be a deal breaker. Given the advantages of the repair strategy, it is definitely worth paying $0.10 or $0.20 per share.

Lastly, our third objective was to avoid increasing the overall risk of the position. For the repair strategy to work, the underlying stock has to rally at least part way back to its original cost. What if it remains at its current price, or continues to fall? If BBB remains at its current price of $30, at the November expiration all of the options will expire worthless. The cost of entering into this strategy was nil, and its ending value is the same. So we may have wasted a little of our time, but there is no financial harm done. Finally, as BBB continues on its downward journey, the strategy does not help (all of the calls still expire worthless) but it does not add to the position’s risk. For every dollar BBB falls below $30 we will lose an additional $400, much less than if we had doubled-up.

  VIX Snapshot

*Third Party Advertisement