This is a cool idea that helps you recover your principal on a stock that just didn’t go your way. This strategy helps you get back to break even and is intended for an investor who doesn’t want to put any more capital into a losing position. Continuing with the Options strategies, this strategy uses call options to help recoup losses on an existing position.
Here is how it works. Let’s say you bought shares of XYZ. You did all of our analysis and it looked like a great company, it looked like a good price, but unfortunately, losses will always be part of the game, and this one turned out to be one of those losers. So, you bought 100 shares of XYZ for $50 and now that stock is at $40. For every 100 shares held, 1 At the Money call option is purchased and 2 call options with a higher strike price are sold which gives you immediate call premium to cover the cost of buying the call option. All options have the same expiration month. These purchases and sales are structured so that the investor’s cash outlay is minimal or none. We are going to assume it cost $3 to buy the call option and you collected $1.50 to sell each of the 2 call options, collecting $3, offsetting the cost to buy the call.
Here is the example from the CBOE website:
It looks as if one of the sold calls is not covered since we only purchased one option, but keep in mind that we already own 100 shares that were purchased at 50 and the call option gives us the right to buy another 100 shares at $40. If this were to happen, our cost basis is $45. If the stock goes above $45, then both sold options are covered by the 100 shares owned and the 100 shares we have the right to buy.
If the stock continues to fall, all the options expire worthless and since it did not cost anything to enter this position, this strategy didn’t affect you at all, but your original shares are still declining.
If the stock remains at $40, the result is the same as the scenario above. The options expire worthless, it didn’t cost anything, and so this did not help nor hurt you.
If the stock rises to $45, the two sold (aka short) options will expire at the money. The purchased call (aka Long Call) will have gained $5. The original 100 shares will have recouped $5 of the $10 in losses. However, since the call option gained $5 and the shares gained $5, the position is now at a break even. As you can see, with this strategy, you don’t need the stock to recoup the entire loss to get back to breakeven. With this strategy, in this example, to obtain the desired outcome, the investor only needed the stock to get up to $45, not $50 to break even.
If the stock rises to $50, the long call is worth $10, the two short options are each down $5 (the stock is at 50, but the option strike price is $45), so the long call and two short calls will cancel each other out. The original shares got back to breakeven.
At this point, the best you can do is break even or close out all the options, and hang on to the original 100 shares if you think that is still a good stock to hold. Keep in mind that this strategy doesn’t prevent the stock from further downside risk, but if it does continue to drop, this strategy doesn’t add any more risk.