How to Use the Repair Strategy
Please note: Commission, dividends, margins, taxes and other transaction charges have not been included in the following examples. However, these costs can have a significant effect on expected returns and should be considered. Because of the importance of tax considerations to all options transactions, the investor considering options should consult with his/her tax advisor as to how taxes affect the outcome of contemplated options transactions.
An investor has purchased 100 shares of XYZ stock at $50 and seen the value of these shares fall to the current price of $40. He is not willing to invest more capital to this losing stock position, doesn't want any more downside risk than he already has, and is happy to just break even. He decides to establish a repair strategy.
This investor could purchase 1 60-day XYZ 40 call at $3.00 and simultaneously sell 2 60-day XYZ 45 calls at $1.50, a strategy that by itself could be referred to as a "ratio call spread" Note that in this case the spread costs the investor no debit (or credit). The cost of the purchased calls ($3.00 x 100 = $300) is fully offset by premium received from the sale of the written calls ($1.50 x 2 x 100 = $300).
The purchase of the 1 XYZ $40 call, gives the investor the right to purchase an additional 100 shares at a cost of $40 per share. The 2 written $45 calls means that the investor could be obligated to sell 200 shares of XYZ at $45 if assigned. Currently, the investor holds only 100 shares, but if needed the long $40 call could be exercised and another 100 shares purchased at $40 to cover the assignment.
Consider four possible scenarios at expiration:
- XYZ falls and closes at $35
- XYZ is unchanged and closes at $40
- XYZ rises and closes at $45
- XYZ rises and closes at $50