Stock Repair Strategy: One Way to Recover from a Position Gone Bad - Miller

All of us get caught from time to time holding a position that suddenly goes bad. A stock suffers a sudden price drop, usually while the market is closed when one cannot do anything about it. It simply closes today at one price then opens tomorrow several dollars down. So what does one do, sell the shares immediately and take the loss or utilize some strategy to try to minimize the loss?

One of the benefits of position sizing is to minimize the impact of these kinds of events. If I build a portfolio with 5% of my account in each position, even a loss of 50% in that one position only accounts for 2.5% loss in my overall portfolio, unpleasant yes but not likely to cause me to lose much sleep over.

Here, I describe an option approach I could use to repair such a position. Of course, each of us has to decide first whether the position is worth saving or not. In the long run, nothing will save one from a large position in a stock like Enron.

Of course, one should consider the chart before going further. Here, BRCM has reached an area of support from which it should spring higher for a while. Ideally, I would execute this repair strategy when it meets some resistance and looks like it's ready to resume its fall.

Option Repair Strategy

The above table details the approach. Here, 1,400 shares of BRCM are owned at a cost of $30.13 per share, and now its price stands at $27.76, so I'm $2.37 per share down ($3,318 in total). This repair strategy calls for one to buy 14 in-the money calls while selling twice that many less in-the-money calls. The idea is that half the short calls would be covered by shares owned and the other half by the additional calls purchased. Ideally, one places this position at a credit. Here, we'll consider going long 14 May 27 calls and short 28 May 28 calls at a credit of $1.66 per share. Note, the calculations are based on the 1,400 shares owned so the short call premium is doubled.

The table considers possible BRCM prices in 108 days at expiration. The impact of each component of the position is considered for this range of prices. If price, for example, at that time was $25 a share ($2.76 down from where it currently is), I would be down -$3.47--a little more than a dollar more than I was at the outset. Contrast that with where I would be if I just held the shares hoping they would go up, i.e., down -$5.13. Too, my ownership basis would have dropped to $28.47 (from the $30.13 I started with) because of the $1.66 credit.

If price were $27 at expiration, I would have improved my position by now being only -$1.47 down (from down -$2.37 that I started with). Both option positions would be worthless, while my stock position would be down -$3.13. If price instead rose just 24 cents to finish at $28 at expiration, my position would now show a 53 cent per share profit, the maximum attainable from this strategy applied here. Beyond $28, shares are called away, and the long and short shares cancel one another.

There you have it, This repair strategy allows me to lower my basis and, at the same time, gives me a chance to recapture much of my losses. Further, it reduces further loses. Its only downside is that it caps the upside should BCRM bounce back strongly over the 108 days.