For instance on Thu Sept 19 2013, $BBRY, was worth $10,50 in the morning, at the market opening, at the same time on the following day Fri Sept 20 2013, the stock price was $8.25. This is a 21% decline in 24 hours! In this situations you most likely as a retail investor will not have the time to close your position before it is too late, and PANG! You are then stuck with a trading loss.
For the purpose of our example, let us say that you had bought 100 shares of Blackbberry ($BBRY) a few weeks ago, on Sept 16th. The share price was then at $10.30. And you have then been hit by a pretty serious decline in the share price, as shown in the diagram below taken from Google Finance.
A sharp trading loss
Some people try to buy more of the falling stock, thinking "if the stock went down so much it is becoming dirt cheap, it will bounce back up tomorrow so I can buy more from it, in order to I can cover my losses". That is not a good idea. Here a few reasons against this:
- If the stock starts to go down, the big mutual funds which are the investors that actually decide the price of the stock, might start selling it to close their position in the stock. And this will definitely push the stock further down.
- You increase your risk by buying more shares so you are becoming like a gambler in the casino, playing roulette or poker thinking that you want to risk more.
Buying a few Call Options instead of the stock itself is even a worse thing to do. Because you not only increase your risk but also are buying options which are overpriced since the volatility in the stock price has probably exploded overnight.
Stock repairing with Call Options
The trick is to go into a stock-repairing strategy:
- Buy a Call Option with a strike price at the current price of the stock
- Sell two Call Options at a higher strike price
The diagram below taken from public data shows the option prices for the ist of options maturing in Dec2013. As you can see in the diagram, the cost of entering the position is minimal. For our example we will do the following
- First, we buy a 8CALL, which is a Call Option with a strike price at the current price level of $8.00, for $65.00
- And at the same time we sell two 10CALL, which are Call Options at a higher strike price of $10.00, for $18.00
What about the payoffs at maturity of the options?
- on the upside a much higher return than the 100 shares position. Which means that you do not need a full recovery of the stock price to fully recover your losses!
- on the down side, virtually the same return as if you had kept your 100 shares. Which means that you do not increase your risk !
To wrap it up: recover your loss if the stock reaches only $9.4
Want to learn more about stock repairing strategies and how they are implemented by professional option traders? Check this article from the Chicago Board Options Exchange (CBOE).