This article is fourth in the series for understanding options. The target audience for this part are long-term investors who can put up with some calculated risk. The previous parts are here.
Options I: Introduction and pricing
Options II: Strategy for the long term investors - writing puts
Options III: Strategy for the long term - writing covered calls
Disclaimer: This part is not for long-term value investors. If you want to earn moderate to good returns (around 20% average) you don’t need to deal with this strategy. The previous strategies in part II and part III are quite safe and can reward you with handsome profit, if you do them right. Also, the risk of losing a lot of money is not something you will have to deal with in those cases, if you use them right. On the other hand, the strategy I am describing here can lose you a bit more money. You need to find a good candidate stock and make good decisions to profit from it. But the strategy is safer and less risky than having a long or short position on the stock.
Situation Let us describe the situation in which you will use this strategy. Suppose that you have a stock that is down 10-20% from the time you bought it. This is stock you do not want to hold for the long term. You are considering selling it. Ideally, you would like to break even on the stock and find a better use for your cash. But on the near term you think the stock is likely to recover. That is a lot to take in, so let me itemize that for you.
- The stock is down 10-20% from the time you bought.
- You are considering selling it.
- You think the stock will recover a bit from its current price.
Outcome The strategy I am going to describe is going to lower your break-even point on the stock without you putting additional capital at risk.
Strategy Let me describe the strategy before we go into some examples and when not to use it. First of all, you need to own the stock to use this strategy. For every 100 losing stocks you own, you will do the following:
- Buy one call option with strike price below the current price of the stock.
- Write two call options with strike price above the current price of the stock.
- Use the same expiration date on both calls. A expiry date within 60-90 days is ideal. This is because you want to sell the stock and not keep it. You can make better decisions on the short term than over a long term.
- Make sure that for the call you buy (will cost you money), you do not pay more than double of what you got by selling the calls which are above the strike price.
Let us take an example to understand the strategy better.
Take stock ABC. You bought 100 ABC at $50 a share and the stock is now trading at $40 a share. You think the stock might recover to $45 or more but you are not really happy with the stock. It is not ideal as a long term holding and you want to get out. If you sell the stock now, you lose $10 a share. If you do nothing then the stock needs to recover by $10 for you to break even. You can put more capital in the stock by buying more of it. If you buy 100 more shares at $40 a share, this will make the average price of your holding $45 a share and then the stock needs to move only $5 for you to break even. Well, what if you do not want to buy more of this stock? To begin with, you want to sell and get out. You are even considering selling it at $40 to free up the cash. Buying more to lower the cost basis does not seem like a good move.
To repair this stock you do the following
- Buy one call at strike price $40 for $2 a share. This would debit $200 from your account.
- Sell two calls at strike price of $45 for $1 a share. This would put $200 back in your account.
- The thing to make sure is that you put no additional capital in the stock. You bought $200 worth of call options and you sold $200 worth of call options. Also, notice that the call may cost more or less in an actual situation. The thing to make sure is that you do not put any additional money in the stock. You need to fund the buying of the call with the writing of the two other calls.
- The date of expiry for both options ideally should be less that three months for better visibility.
Let us see what happens in the following scenarios:
|Falls to $35||All your options expire, no point using the $40 call option to buy more stock, and the $45 call options will not be exercised by the buyer either.|
|Stays at $40||All your options expire, no point using the $40 call option to buy more stock, and the $45 call options will not be exercised by the buyer either.|
|Recovers to $43||The $45 call options will not be exercised by the buyer but you can exercise the $40 call option to buy the stock at $40 and sell it at $43 on the open market. Or you can just sell the option for $3/share profit. Congratulations ! You have lowered your cost basis to $47 and you can try again if your thesis still holds.|
|Recovers to $45||You sell the $40 call option for a cool $5 profit. You sell rest of the stocks at $45. For each stock you get $50, which is what you paid. Congratulations ! You got out of the stock without any loss even though the stock recovered to $45 and not $50 (your original buy price). Furthermore, you put no additional capital at risk.|
|Recovers to $50||Each $45 call options you sold have value of $5 each. The $40 call option you bought has value $10. So, the options cancel out. You can sell the stock at $50 and get out.|
|Recovers to $60||Each call option you sold at strike price $45 is worth $15. The call option you bought at strike price $40 has value $20. The $10 loss you see, you can recover by selling the stock at a $10 profit (you bought at $50 and can now sell for $60).|
Risks The strategy is not risk free. From the table we make the following observations
- If the stock falls, you are worse off. You should have sold the stock rather than trying this strategy.
- If the stock goes beyond the strike price, you get no profit from the move up. For example, when the stock recovered to $60, you could have made $10/share rather than just breaking even.
Don’t try this strategy with
- Stocks which have a chance of going further down. In the current market Cemex (NYSE:CX), Xerox (NYSE:XRX), Bank of America (NYSE:BAC).
- Stocks that have very strong FCF, good balance sheet and growth opportunities. At the moment, Novartis (NYSE:NVS), Johnson and Johnson (NYSE:JNJ), Swatch, Coach (NYSE:COH). In this case, you will be much better off buying more when the prices go down. Alternately, see Options II: Strategy for the long term investors - writing puts and consider writing puts near the market price to further bring down your base price.
- If you can’t buy and sell the calls in the correct way i.e., you can't fund the call from selling the two other calls.
What this strategy offers
It can help free your money when you are slightly bullish on the stock but also if you want to sell it and free your cash.