Sometimes bad things happen to good stocks. And when this happens, good stock trades can quickly become broken stock trades. Just like a rising tide lifts all boats, when the tide goes out, the boats go lower. Massive market sell-offs show no mercy, are not selective, and take no prisoners.
What can you do when a stock you bought (and like) heads lower? You can:
A) Do nothing. You bought it for the long term.
B) Sell it and take the loss.
C) Buy more at a lower price (hey, if you liked it at 20 you gotta love it at 15, right?)
D) Use options strategies to lessen or mitigate your loss from the broken stock trade.
There’s nothing wrong with A. There’s nothing wrong with B either, provided you did not let the loss run away from you. Some of the best trades I’ve ever done involved taking a small loss before it turned catastrophic. C is stupid. I wouldn’t advise reinforcing failure with a “double down.” In Europe this is called the “Monte Carlo Fallacy.” If the roulette wheel is red 25 times in a row and you keep betting with more money on black each time you’re likely to go broke before black comes up.
So, let’s look at D, using options. Before I begin, no strategy will help you if the stock goes to zero. There was no way to repair an Enron position, for instance. But, fortunately, that doesn’t happen very often. Let’s look at a realistic repair strategy for a broken stock trade. It simply involves doing a 1:2 vertical call spread for a credit.
For instance, take recent Tradespoon pick Rackspace Hosting (RAX). Let’s say you own 100 shares you bought at 40. The stock is now 35.
You can buy one time the February 36 call at 2.50 and sell two times the 39 call at 1.50 for a one-point credit. If RAX expires under 36 you collect the one-point credit and do it again the next month. If RAX expires above 36 you make 3 on your options.
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