The world of options is a very interesting one, and one of it that caught my attention in my early days is this strategy called the option repair strategy.
In this blog post, I explain what it is about - and why I personally don't use it (even though it works).
Let's get started.
What Is The Option Repair Strategy
The repair strategy is used when you want to "repair" an existing losing position. It is done by buying one call option and selling two call options for every 100 shares you own.
(Yes, you will need to have at least 100 shares, to execute this strategy)
How does it actually work?
Well, let's say I bought 100 shares of ABC at $100 and the stocks falls to $80 after the CEO of ABC was caught in a scandal. However, I believe that the share price should at least bounce back a little. But for me to breakeven, ABC will have to increase to $100.
So what do I do then?
- I sell two call options at the strike price of $90 - and collected $100 in option premium.
- I use the $100 option premium that I collected, to buy a call option at a strike price of $70.
- Both of these has the same expiry.
Notice that I am using my sell call option premium collection to pay for my buy call options. This means that I do not pay any cash to do this option repair strategy. (Or rather, very little cash in reality.)
Now, let's consider the various scenarios at the end of expiry:
1. ABC's stock stays at $80
Remember that a sell call expires worthless if the share price is below the strike price. This means that my sell call with a strike price of $90 expires worthless - I get to keep all the option premium. Consequently, my buy call doesn't give me any additional profit - but neither do I have a loss. Remember that I bought these call options for free using the option premium I collected from the sell calls.
So this scenario means nothing much - I could just repeat the option repair strategy again.
Position | P/L |
|---|---|
2 Sell Calls | $0. Expired worthless |
Buy Call | $0. |
100 shares bought at $100 | ($80-$100)x100=-$2,000 |
Overall P/L | -$2,000 |
2. ABC's stock increase to $85.
Here is where it gets a little interesting.
Again, since the share price is below my strike price of $90 of my sell calls - I get to keep the entire premium. This premium was used to pay for my buy call options. My buy call options have profit an additional $5 due to the intrinsic value of the stock. Since an option represents 100 shares, that is $500 of profit.
Now, let's take a look at each of my position:
Position | P/L |
|---|---|
2 Sell Calls | $0. Expired worthless |
Buy Call | $500. Realised Profits |
100 shares bought at $100 | ($85-$100)x100=-$1500 |
Overall P/L | -$1500+$500 = - $1000 |
Can you see that by doing the option repair strategy, I reduced my loss by $500 and now I can repeat the option repair strategy again. Because, if I have not done the option repair strategy, my shares would still be at a loss of $1,500.
Wait wait, that sounds too good to be true - does that mean if I learn options, I will never lose money?? Hang on, there is a third scenario - when the share price skyrockets.
3. ABC's share price shot up to $110
Here is where the disadvantage of an option repair strategy rear its ugly head.
Remember that we have two sell call options at $90 strike price. If the share price shot up to $110, this means that each call option will be losing $20. With both sell call options, that is a loss of 2x-$20 X 100 = -$4,000. (Remember that an option represents 100 shares.)
But, it is not all doom and gloom. We have a buy call option, remember?
Our buy call option will have an intrinsic price increased of $30. Remember that we bought the call option when the share price was at $80. So $110 - $80 = $30. Since an option represents a 100 shares, that is a $3,000 profit.
Finally, our 100 buy shares which we bought at $100 -> this gives use ($110-$100) x 100= $1000 profit.
Position | P/L |
|---|---|
2 Sell Calls | -$4,000 |
Buy Call | $3,000 |
100 shares bought at $100 | $1,000 |
Overall P/L | $0 |
So finally, the option repair strategy paid off - and you managed to walk away with a breakeven.
But for those who are more keen eye - you would have realised, if you did nothing at all, didn't do the fancy option repair of selling two calls and buying one call option - take a look at the profit of your 100 shares. It would have given you a profit of $1,000. But because of the option repair strategy, the overall P/L became $0.
In this case, it is a classic case of "itchy fingers". Because if you didn't do anything, and think about the long term, you would have profit $1,000 instead of $0.
Why I Don't Do Option Repair
Usually, if my stock is having a paper loss - I would much rather just buy more and add more tranches to lower down my average purchase price. It is much more straightforward. Sometimes, this is hard to do, especially if the stock is in the red, but if you have done your homework on the fundamentals, valuations and did proper portfolio sizing - you will realise that any stock downturn presents a great opportunity.
An option repair also limits your upside as demonstrated in the third scenario. If you understood the fundamentals of the company and know that it will increase over the long term - doing an option repair adds unnecessary risks of limiting your upside. It is simply not worth the effort at all.
An option repair also takes time. Most of the time, people need to use option repair simply because they blindly invested in poor quality stocks or they do not understand what they were investing. Therefore, they look at option repair as a strategy to try to breakeven their losses. If the stock does not appreciate, this could take months for an option repair. A better alternative, could just be to cut your losses, recover the remaining capital and invest it in a fundamentally good stock that you understand. You will likely breakeven much faster that way.
In conclusion, I don't do option repair because it is simply not worth the time, energy and attention. The stock market is a place to exchange money for more money, and not time for money.