How To Rescue Your Losing ETF Position With Options

by on May 6, 2013 | ETFs Mentioned:

Exchange-traded funds (“ETFs”) are an attractive way for investors to easily gain exposure to specific countries, sectors, industries or asset classes. Just like equities, many ETFs have options that can be bought or sold on them, enabling traders and investors to employ unique strategies to control their positions. In this article, we’ll take a look at one options strategy that can be used to quickly recover from poorly performing ETF investments [see ETF Call And Put Options Explained].

What Is a Stock Repair Strategy?

The repair strategy is designed to help long investors more quickly recoup their investment losses in an equity that has fallen. While holding onto their losing long ETF position, investors simply purchase one call option and simultaneously sell two call options with a higher strike price for every 100 shares owned. The result is an options position that reduces the equity ETF position’s breakeven point without any cost other than the opportunity cost of forfeited upside [see also ETF Collar Options Strategy Explained].

For example, suppose that you own 100 shares of SPY that you purchased at $80.00. Since then, the ETF has fallen to $50.00, resulting in a 37.5% unrealized loss. You could simply liquidate the position at a loss, double down and buy another 100 shares, or utilize the repair strategy to reduce your breakeven point with no upfront cost. The repair strategy in this case involves writing two call options and using the proceeds to purchase a put option [see How To Take Profits And Cut Losses When Trading ETFs].

Who Is the Repair Strategy Right For?

There’s a popular saying on Wall Street that investors would be wise to keep in mind: there is no free lunch. The repair strategy is designed to help quickly recoup losses, but only works when the underlying ETF recovers a bit, too. Moreover, the repair strategy may involve no up-front costs, but the capped upside means investors are paying an opportunity cost. That is, if the ETF rises further than you expect, you may actually be forced to sell earlier than you’d want.

The repair strategy is therefore ideal for investors that are long on an ETF that has lost a fair amount of value, but which they believe will recover in price over time. However, the investor shouldn’t be too confident in the recovery, since they may then be better off simply doubling down on their position or pursuing a more bullish strategy. In options-speak, the repair strategy is considered a neutral to moderately bullish strategy for long-term investors [Download 101 ETF Lessons Every Financial Advisor Should Learn].

What Are the Risks and Rewards?

The repair strategy has unlimited downside risk and capped upside risk, with the tradeoff being that the breakeven period is moved forward at no upfront cost. While investors can exit the position before expiration and keep the long equity position in tact, the net gains and losses will still be equal to the new “breakeven point” of the repair strategy.

Maximum Profit – The maximum profit from the repair strategy is limited to the strike price of the call options written to enter into the position, since one of these options is covered by the underlying shares and the other is cancelled out by the first in-the-money call option.

Maximum Loss – The maximum loss from the repair strategy is potentially unlimited, since the call options will simple expire worthless if the stock doesn’t rise past their strike prices and the underlying stock will remain in place at a larger paper loss.

How to Salvage Bad Trades with the Repair Strategy

Let’s take a closer look at the strategy in practice to fully touch on the topics that we’ve discussed in this article. Suppose that we have the same 100 shares of SPY that we purchased at $60.00 and now still own at $50.00 in January. While we are bullish on SPY moving forward, we’re skeptical that it will perform much better than the 16.7% that we’ve already lost. As a result, we’ve decided to implement the repair strategy to reduce our breakeven point [see also ETF Protective Put Options Strategy Explained].

To establish the strategy, we may purchase the following options:

Option Premium Strike Price
Buy 1 March Call Option $2.00 $60.00
Sell 2 March Call Options $1.00 $65.00

Looking at the example options above, the $1.00 received from the two written call options offsets the cost of the $2.00 paid for the purchased call option, creating a net credit/debt of zero – or a “free” position that investors can enter into with no upfront cost.

Now, let’s take a look at three different scenarios and overall returns in March:

Scenario With Repair Strategy Without Repair Strategy
SPY falls further to $40.00. $(1000) $(1000)
SPY moves to $55.00. $0 $(500)
SPY jumps to $65.00. $0 $1,500

The Bottom Line

In these scenarios, the call options all expire worthless when SPY is below $60.00, meaning that the losses are the same. When SPY moves to $65.00, the call option purchased is worth $500 and the underlying stock has lost $500 from the original purchase price, which means they cancel each other out to create a breakeven point. This breakeven is sooner than the $60.00 breakeven point for the non-repair strategy position, although it comes at an opportunity cost.

The repair strategy is a useful way for ETF investors to recoup dramatic losses when they are moderately bullish on a recovery without putting up any additional capital. Of course, investors should simply sell the ETF position when they are bearish, since the repair strategy doesn’t help in that case. Conversely, investors should simply purchase more stock or call options when they’re bullish, as the repair strategy limits potential upside.

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Disclosure: No positions at time of writing.