Mark,

Please help in this situation.
Suppose one buys a stock at 93 and it declines to 80. Now one decides to do a repair strategy via a call ratio spread.
1. Sell May 85 calls(short)
2. Buy  May 80 calls(long)
The idea is to lower the break-even point.

Suppose the stock declines to 60.
In this case the 85 calls(short) will show a profit and the 80 will lose value.
What should one do? Wait for the stock to go back up to 85 or just close all the calls and do another call ratio spread?

Thanks again..


Hello nameless,

Let's begin at the end.  Why would you believe that it's going to be profitable to continue to own shares of a stock that dropped from 93 to 80?  Why would you continue to hold the stock as it declines to 60?  I'm not suggesting you sell because you know the stock is going to decline further, I'm just asking: why own shares of a business whose shares are steadily dropping?

Why do you believe waiting for it to 'go back up to 85' is reasonable?  What makes you think (if you still own shares at 60) that it's going to have a substantial rally and return to the 85 level?  Keep in mind that this specific stock doesn't owe you a profit. The questions you must ask yourself are:  Is this the best place for my money NOW? Does owning this stock give me the best chance to grow my account value FROM TODAY FORWARD?  What you have lost is gone.  Your goal is to make money in the future.  To that end, own stocks you WANT to own.  Do not simply hold onto losers looking to get even.  OK enough preaching.

Now, about the 'repair strategy.'  If you were to buy one May 80 call and sell one May 85 call, that would be another bullish play, costing you even more money if the stock declines further.  When you initiate the 'repair strategy,' you do so with the intention of sacrificing upside potential in return for a better chance to recover all, or part of your current loss. And you also do it with NO ADDITIONAL DOWNSIDE RISK.

To accomplish that, you buy ONE May 80 call and sell TWO May 85 calls, paying approximately zero for the combination (i.e., buy one May 80 call at $4.00 and sell 2 May 85 calls at approximately $2.00 each.  If you can collect a cash credit for the combo, even better).  You can sell extra calls because you own 100 shares of stock.  Thus, the resulting position has no naked short calls - and you don't want to take the risk of being naked short calls, even if your broker allows you to do so.

This new position has limited upside potential because you have two longs (one option, one unit of stock) and two shorts.  But, it cannot lose more than your current position on the downside.  The advantage is that you can make some money if the stock holds above 80 at expiration - when the 80 call retains some value and the 85s expire worthless.  And if the stock is above 85, you sell your stock at 85 (because you are assigned an exercise notice) and you earn $500 on the May 80/85 call spread.  Thus, you collect $90, getting back to even (or close) on your trade.

But, if the stock falls further, the repair strategy accomplishes nothing. Thus, if you continue to hold and (do nothing while) the stock declines to 60, I don't know what to tell you.  If you want to initiate another repair strategy at that point, then you would be forced to either buy back one (of the two) 85 calls you sold so that you can do another 1 x 2 call spread.  Thus, the answer is yes, close the May 80/85 position - if you can collect a cash credit for doing so, otherwise simply buy in one of the 85 calls - perhaps for $0.01 or $0.02.  Then you can do another repair on this very broken stock: Buy one Jun 60 (or 65 call) and sell two Jun 65 (or 70 calls) - again being certain not to pay much more than zero for this spread.

I hope this was a hypothetical question.

Mark

--
Mark D. Wolfinger
The Rookie's Guide to Options:
The Beginner's Handbook of Trading Equity Options