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Even the best investors can sometimes get into the wrong stocks. So what should you do? Sell? Hold? Double-up? There is no scientific answer, but options offer a unique alternative.

The place to start is with your forecast. If you believe the price will continue downward, then the logical choice is to sell. An old saying is "lose your ego, not the farm."

However, if you are still bullish, then buying additional shares, or doubling-up, may be appropriate. Doubling up lowers the break-even price on the total position. If the stock price continues to decline in price, however, you lose twice as much.

A third possibility, the "Stock Repair Strategy," lowers the break-even point without increasing risk. Consider the following example.

Assume that Greg owns 100 shares of XYZ stock at a cost of $60 not including commissions. Unfortunately, the shares are now trading at $50. Although unhappy, Greg believes that the decline is over and that the price will rise to $55. He also has changed his goal. Now, he just wants to break-even without having to commit additional capital and without having to assume additional risk.

Here is how Greg might implement the "Stock Repair Strategy." This transaction must be established in a margin account.

Continue holding 100 shares of XYZ (cost $60, currently $50)

Buy 1 90-day 50-strike Call at 3

Sell 2 90-day 55-strike Calls at 1 1/2 each

Note that the net cost of the option position is only transaction costs, because the premium received from sold 55 Calls offsets the premium paid for the purchased 50 Call.

Also note that both of the short 55 Calls are covered. One is covered by the owned XYZ shares, and the other is covered by the purchased 50 Call (this is known as a spread).

Table 1 shows the profit or loss at expiration of each part of this strategy. The conclusion is that this strategy might get all of Greg's money back, not including commissions, on a stock price rise to $55 or higher at option expiration.

Stock Price
At Option
Expiration

Profit/(Loss)
On Stock
(Cost $60)

Profit/(Loss)
On 1 Long
50 Call
(Cost 3)

Profit/(Loss)
On 2 Short
55 Calls
(Sold for 1 1/2 ea.)

Total Profit/(Loss)

(0)

(7)

(0)

(5)

(0)

(10)

(3)

(10)

(15)

(3)

(15)

There are three possible outcomes at expiration.

First consider the downside risk. If the price of XYZ stock is at or below $50, then all options expire worthless. Since the net cost of the option strategy is zero, not including commissions, then the strategy does not help, but it also does not hurt! Greg still has the risk of XYZ declining in price, but he does not have any more risk, as he would have if he had purchased additional shares.

If the price of XYZ is above $50 and at or below $55 at expiration, then the short 55 Calls expire worthless, but the 50 Call will have value, and that value will help to lower Greg's losses. Greg could either sell the 50 Call or exercise it.

The third possible outcome is that XYZ stock closes above $55 at expiration. In this case, it is likely that the two short $55 Calls will be assigned. Greg will be then required to deliver 200 shares of XYZ stock. This will not be a problem, because he owns 100 shares and he can exercise his 50 Call to purchase another 100 shares.

The possibility of an early assignment must not be overlooked. But, again, this should not present a problem, because both of Greg's short 55 Calls are covered.

The important concept is that Greg's new break-even stock price is $55, the same as if he had doubled-up. The stock repair strategy is not "better" than doubling-up, it is just different. It is, therefore, an interesting alternative.

Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options. Copies of this document are available from your broker or The Options Clearing Corporation, 400 S. LaSalle Street, Chicago, IL 60605. For Tax implications of this, or any other strategy, please contact a tax a tax advisor. 2001 Chicago Board Options Exchange, All Rights Reserved.

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