Strategies for under water stock?

Question

I have a stock that I bought at $40 and it is now $22. Are there any strategies that can be utilized to reduce the loss?

Covered calls with a $40 strike offer very little premium. The $30s are the only strike price worth choosing but doing so could lock in a $10 loss (less the premium received) if the stock rises and I'm assigned. Are there any other option strategies that could work better?

Also, the margin requirement on the stock has increased to 60%. So it's difficult for me to throw more money into this because it would tie up an excess amount of cash.

I'm guessing that a loss is in the works for me but at this point I'm only looking to reduce the loss without dumping too much cash into the hedge.

Answer 1

For a stock that has lost 45% of its value, there is no zero cost option strategy that can be utilized to recover such a loss. With a fair amount of luck, you might be able to recover a chunk of the loss if the stock cooperated, but they rarely do.

For a stock that has dropped maybe 10-20 per cent, you can use a Repair Strategy to recover losses. For every 100 shares that you own, execute a 1x2 Ratio Spread (buy one call at a lower strike and sell two calls at a higher strike. The combined position will be equivalent to a covered call and a bullish vertical call spread. All short calls are covered.

The premium of the higher strike call should be at least 1/2 the cost of the lower strike so that the Ratio Spread costs nothing. A credit is even better. If the Repair does not work out, you'll have the same downside potential as if you had done nothing, namely just holding the stock and hoping for a recovery. To the downside, a failed no cost Repair has no impact on the overall position.

To achieve break even, if using an ATM long call, the short strike should be approximately midway between the current price and your break even price. IOW, the width of the vertical spread (the difference in strikes) should be about 1/2 the amount of your paper loss for you to break even.

There are two subtle points but they are merely underpinnings.

(1) Dividends inflate put premiums and deflate call premiums. This has a greater effect on options closer to the money which makes a Repair more expensive, relatively speaking.

(2) Implied volatility also affects the price of a Repair. The lower the implied volatility, the more costly a Repair will be. The higher the implied volatility, the larger the available credit which may then enable you to use lower strike prices which means a higher probability of the upper strike being reached and the Repair succeeding. So in the magical world of dumb luck trading, any news event that moves implied volatility up (and not price down) would present a better Repair opportunity.

Do you need to understand these underpinnings? Not really. All you need do is look at the option chain and see if a viable Repair exists. Go out a week (or month) at a time to see if an option pairing meets the no cost requirement. You want the closest expiration possible that provides a no cost Repair and break even. These criteria are not etched in stone. If you want to pay a small premium for the Repair or if you want to shoot for a price less than break even, go for it.

You DO NOT want to go out many months with a Repair because prior to expiration, short calls retain time premium and they will be a drag on the long call gain, hindering the Repair from achieving its full value prior to expiration. To get the maximum amount from the Repair at expiration, the underlying would have to be at or above the upper strike. To get the maximum amount from the Repair prior to expiration, the underlying would have to be well above the upper strike in order to drive the short calls to parity (no time premium remaining).

An increase in implied volatility prior to expiration will also diminish your ability to break even. For example, if you executed a no cost 6 month $22/$26 Repair and it rose to $26 in one month with an IV increase, you might realize only 1/2 to 2/3 of the Repair's maximum profit. If it then dropped - Poof! - you'd have nothing to show for your effort. In such a scenario, parity might be in the $32+ area.

You can also use this strategy for brand new stock purchase. This is not a Repair since you aren't underwater (paper loss). For example, if XYZ is $70, if you could execute a $70/75 ratio combo for no cost and if XYZ was above $75 at expiration, you'd net $80. From $70 to $75 you would make $2 for every dollar that XYZ rose ($1 on the stock and $1 on the long call). So at $71 at expiration, you'd net $2. At $72 you net $4, all the up to $75 where you'd net $10.

I tend to close Repairs when they have achieved 80% of the potential gain and then either add a new Repair at higher strike prices or perhaps shift over to writing covered calls since the premiums available might then be more acceptable.

You can read more about this at: http://www.cboe.com/strategies/advanced/equity/stock-repairs-strategy/part1

Answer 2

If you made a new portfolio, would that stock be in it?

You are wallowing in something called the fallacy of sunk costs. I've spent plenty of time there myself, thinking that this stock "owes you something" (no, the dice have no memory) and that "it'll recover if you stick in it long enough" (maybe, but in that precious time, other stocks will do better). It's a mental trap and a false signal.

Yes, the stock may go back up. But you need to free your mind into picking whichever stock is likely to go up the most. If you identify another stock that is more likely to perform better than this stock, then without further ado, sell this stock and buy that other.

Here's what you don't want

• this stock is at $22. You hold it for 5 years and it limps back up to $44. YOU WIN.
• you know today that ABCD stock will do better. Yup; in 5 years it goes from $22 to $640.

In this scenario you didn't make $4/share. You lost $600/share because you were stuck on a loser stock.

Get it? No sane person building a new portfolio would buy this stock today when today's knowledge tells you ABCD will do much better. They would buy ABCD.

Treat every minute like a brand new market

There is no rear-view mirror in stock trading. No stock "returns to a price", ever. A stock price may rise again if today's fundamentals support that higher price. Point is, don't let nostalgia make you linger a minute too long. (And "nostalgia" is exactly what chasing yesterday's price is.)

Every day, every minute, look at the portfolio you have now - scratch that - don't look. Instead look de novo at the portfolio you want to have going forward. If there are any differences between your ideal and your present, fix them instantly, without a single hesitation or regret.

You owe that old stock nothing. It owes you nothing. (And even if you think it does, it is uncollectable.) Living well is the best revenge, and the best way to "make that stock pay" is pull your remaining capital out of it and put it in a stock that will pay.

Tax considerations

The only nod I will give for remaining in a loser stock is your jurisdiction's tax law. For instance I am in the USA where profits on stocks held less than 1 year pay double the taxes of long term stocks. Don't put too much emphasis on this factor. Know how to game your own country's tax system, and act accordingly. (it isn't cheating, if they didn't want it to be that way, they'd have changed it.)

In any case, selling a stock at a loss allows you to take a tax writeoff for that loss, canceling taxes on the same amout of profits from other stocks. So if you made $30,000 but lost $12,000, you only pay taxes on the $18,000 net gain. Even if the whole year is a net loss, in the US there are rules for carrying that loss forward to cancel taxes on later years' profits.

Complicated trading games

I make it sound really simple. It is. Another post discusses very complicated trading games that you can do to game the stock's price and try to extract a profit. I am not saying those games are wrong. I am saying this stock isn't special and only false nostalgia says otherwise.

You can play those games if you want to. You can play them with any stock. Play them with the stock you feel is best suited for the game. There is no reason to be fooling around with this stock.

Answer 3

The fact that you bought it at $40 is completely irrelevant (other than for tax purposes). If there's a strategy that you, as someone who bought the stock at $40, can pursue to get $18 dollars back, then anyone else could use that strategy to buy the stock at $22 and get a free $18. Clearly, there's no reason to believe that such strategy exists.