How to Repair a Broken Stock

Despite the recent market rally, fully 86% of the stocks that make up the S&P 500 remain at least 20% off their 52-week highs. Sadly, big gainers like Palm (Nasdaq: PALM  ) and Green Mountain Coffee (Nasdaq: GMCR  ) were rare occurrences over the past year. So unless you put fresh cash to work in the past two months -- and if you did, nice work -- the odds are you have a number of stocks in your portfolio in desperate need of repair.

Wait. You can repair stocks?
Not all stocks are ideal candidates for the repair strategy I'm about to discuss -- namely, strong companies that generate plenty of free cash flow and are worth holding for the long run. For instance, I wouldn't sell stocks like Costco (Nasdaq: COST  ) , Wal-Mart (NYSE: WMT  ) , or IBM (NYSE: IBM  ) just because your shares might be 20%-30% below what you originally paid for them. In those cases, you're better off averaging into those positions with more cash to lower your cost basis. Alternately, consider writing puts at strike prices near the going market price.

Similarly, the strategy won't work on stocks you bought that fell too sharply, like Eastman Kodak (NYSE: EK  ) or AIG (NYSE: AIG  ) have this year. If you're not prepared to add more cash to these investments, it's probably best to sell and take the loss (and gain a potential tax write-off).

No, the best stocks for the repair strategy are the true laggards in your portfolio. They're probably down 15%-25%, and you have no interest in holding onto them for the long run. Ideally, with these positions, you just want to break even and free up your cash to put into a better investment. Fortunately, the stock repair strategy lets you do just that.

OK, get to the dang strategy already!
For every 100 shares of a losing stock you own:

  1. Buy one call option at a strike price below the current share price.
  2. Sell (write) two call options at a strike price above the current share price.
  3. Use the same expiration date for the options you buy and sell.
  4. Typically, use options that expire in 90 days or less.

Did you get all that? It's a lot to process, I know, so let's walk through an example. Say you bought 100 shares of Company XYZ at $40 a share, but the company hasn't performed as well as you expected. With XYZ now trading at $30 per share, you're down 25% on your investment, and you just want to break even on the trade and move your cash elsewhere.

To repair the XYZ position, you could buy one July 30 call for $2.50 (a debit of $250), and simultaneously sell two July 35 calls for $1.25 each (a credit of $250), and your options positions would pay for themselves.

Great. What happens now?

If your $30 stock...

Then...

Falls to $25 at expiration

It's a wash. All options expire, and you've only lost on commissions. You can try again. Unfortunately, the underlying stock's value has fallen even further.

Gains a little -- say, to $32.50

You make $2.50 per share on your $30 call option, and you've lowered your original cost basis by $2.50, to $37.50. You can use the strategy again.

Recovers to $35

Huzzah! You make $5 per share on your call option, reducing your cost-basis to $35, and your stock is called away at $35. Congratulations, you've broken even.

Soars to $50

You miss out on the stock's unexpected upside, but your trades still cancel each other out, and you still break even.

It's important to note that the repair strategy isn't risk-free. As you can see, it does not protect you from additional downside in the shares you already own -- nor does it offer you a profit above your break-even price. If you think your unwanted stock runs the risk of a sharp near-term decline, just sell it.

What the stock repair strategy offers -- a chance to breakeven on a lagging stock in your portfolio -- is worth considering before you take the loss.

We're teaching all types of options-related strategies like this at our Motley Fool Pro real-money investment service. We're also building a long-term stock portfolio, and using other option strategies both to generate income and create better buy and sell prices on our stocks. If you would like to learn more, simply enter your email below.

Pro analyst Todd Wenning has no cure for the summertime blues, but fully endorses cheeseburgers at the beach as a repair strategy. Green Mountain Coffee Roasters is a Motley Fool Rule Breakers selection. Costco is a Motley Fool Stock Advisor pick. Costco and Wal-Mart Stores are Motley Fool Inside Value selections. The Fool owns shares of Costco and has a disclosure policy.


Read/Post Comments (10) | Recommend This Article (28)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 05, 2009, at 3:07 PM, madmilker wrote:

    sell it! and buy pork bellies...a can of snuff...a new hoe for the backyard garden and plenty of seed.

  • Report this Comment On June 06, 2009, at 1:15 AM, MartinLois wrote:

    The only problem I have with J.C is he seems to be a month late on his picks. Otherwise I find his show entertaining. Much better then the fear mongering on fox.

    When Cramer finally gets around to picking one of my stocks I always cringe because i know it's going down in the short term.

    To Truth is'nt stupid I agree that you could make a nice supplemental income on divs.

    But have you ever researched the power of compound interest. Depending on your time frame you could retire a millionare.

    http://earnmostmoney.blogspot.com

  • Report this Comment On June 09, 2009, at 1:23 PM, ZeberdeeSpring wrote:

    Advise needed on Green mountain coffee.Price drop should I hold ,sell,or buy more coffee.(GMCR).Thanks ZSic

  • Report this Comment On December 05, 2009, at 2:10 PM, rboard2 wrote:

    my stocks ge,idcc,hban

  • Report this Comment On January 23, 2010, at 8:58 AM, GiovanniO wrote:

    I am new to options and still trying to get my head around it.

    I found the repair strategy quite interesting for a position in VMW that is way underwater. Lots of positive sentiment on this stock (at the current price) in caps but I would prefer getting out (at breakeven or not as much of a loss) and putting my money elsewhere.

    Could this repair strategy work here as I am down more than 35%?

    Thanks,

    -g

  • Report this Comment On June 14, 2010, at 4:40 AM, pasky2112 wrote:

    Giovanni,

    Sell calls for VMW if you think it is going down, sideways, or slightly up. Sell the call for the front month ahead (if June, sell July) Sell the call for a strike price that you are willing to sell the stock at. (break-even or acceptable loss) Put a stop loss limit on the calls you sell (they can lose unlimited $, potentially as stock goes up to infinity in theory) A loss limit i use is from 50%-100% depending on how volatile the stock is. If the stock goes up past the strike price, you'll have to sell your stock at that price in lots of 100 shares per call contract. But you already picked that price ahead of time as acceptable. Plus, you can offset your 'losses' by the amount of $$ (premium) you sold the calls for. There are a TON of ways to play your situation but that is the most basic. Research 'Covered Calls' for more detail. Optionetics.com is a good start. Remember the K.I.S.S. principle too.

    HTH.

  • Report this Comment On June 14, 2010, at 4:53 AM, pasky2112 wrote:

    Giovanni,

    The best outcome would be that your calls expire worthless in July and you get to keep the premium you collected selling the calls PLUS you get to keep your stock. You could think of those premiums as 'dividend' collection... helping to reduce your cost of owning the stock, also. Just don't forget to use the stop loss limit. Also, you sell the calls via 'Sell to Open'. Basic option training on 'covered calls' and a quick phone call with your broker (don't place the trade with them...they usually charge higher commission for phone orders) will get you where you want to be. Then you'll see how it all works and wish you'd done it a long time ago. ;-)

    Good luck. I hope to hear how you do.

  • Report this Comment On June 14, 2010, at 5:13 AM, pasky2112 wrote:

    One important peice of advice i wish I had used...use a 'paper trade' platform FIRST to see how these stategies behave BEFORE you actually put up your clams. You'll get 'free' lessons and be much more confident going into a money trade once you get the 'feel' of how the parts come together for the trade. This is true for options more than any other security, IMHO, since there are a lot of variables and things may not always turn out how you'd expect; more-so than pure stock plays alone, for sure.

    OK... I'm done.

    Todd, thank you for this article. It's a great hedge to play exactly as you laid it out.

    Thanks all!

  • Report this Comment On December 05, 2011, at 1:42 PM, TacticalOptions wrote:

    Here's a good basic description of the stock repair strategy using ratio call spreads.

    http://sellacalloption.com/2011/10/

  • Report this Comment On May 05, 2013, at 4:54 AM, egauravjain wrote:

    In the example of XYZ, why don't we just sell 1 Call for 35 and get the cash in hand - It will lower the cost basis by the amount of premium received. I am trying to figure out what benefit is derived from buying the 30 Call along with selling 2 35 Calls.

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