How the options react in three different scenarios: up, down, and stagnant.
The hard realty is that we are $5,000 down in the trade. This deficit we inherited at the time of purchasing stock. Now stock market can behave in three different ways i.e. up, down, and stagnant. Let’s try to see how these states will affect us and what will be best stock repair strategy for us.
In case of downward trend, the option position will not incur additional loss. Practically we did not do anything to initiate this strategy so we will not make any substantial loss on the spread even if stock trades a bit further down.
As spread will not add to the present loses of our stock, we are at a major advantage in this situation.
If stock trades below $30, February 30 calls as well as February 35 calls are both rendered useless. As we did not spend anything in the preparation of tock repair strategy, so we did not make any extra loss. In such situation our stock position will follow the downward trend but effect or loss will not be compounded.
In the second case, let us assume stock stays stagnant and closes at $30.00. Situation will be again favorable to us, as it will not add to our losses. This scenario will also render the February 30 calls and the February 35 calls useless.
In case market moves up, impact of the stock repair strategy will be apparent. How do we find out the implications of the repair strategy? One way to see, how this strategy will work in this situation is to fix stock price at different levels. With the stock at $31.00, the Feb 30 calls are in the money and will be worth $1.00 while the Feb. 35 calls that you sold are out-of-the-money and will be worth 0.
You will get $1.00 value for 1 by 2 spread. You purchased the spread for “even money” so you now have a $1.00 profit on the spread. As the stock is still with you, it is also up $1.00. So, this movement of $1.00, allows you to recover $2.00 of your losses back. This recovery will continues to work this way as the stock rises up to $35.00. At $35.00, the Feb. 35 calls are still useless; therefore the 1 x 2 spread which is with you now, has its worth equal to $5.00.
As the situation stands stock is recovering from $30.00 to $35.00 and the spread earning $5.00. You are even as far as overall position is concerned. Your initial loss was $10.00 on the stock when trading was down from $40.00 to $30.00. Stock Repair Strategy (1 x 2 spread) allowed you to recover substantially from the original loss ($40 -> $30 -> $35) without taking any additional risks, as in the case of doubling down.
Now, if you were concerned about being long only 5 options versus being short 10 options, you should be congratulated for your observation of potential risk. Once the stock starts trading over 35, the Feb. 35 calls will become potential source of added value. As the stock continues up the Feb 35 calls will prove more productive than Feb 30 calls in value.
However, there is not cause for concern because the 5 ITM calls that you own, coupled with the 500 shares of stock that you originally bought, are now moving up in tandem with your short calls, so any loss you experience with them over $35 will be ‘covered.’
Do no t forget that you still own 500 shares of XYZ. It does not matter how higher stock goes above $35.00, each one of the Feb. 35 calls will be covered. Five will be covered by the long Feb. 30 calls, which created a 1 x 1 vertical call spread (Feb. 30 – 35 call spread.) and the other Feb. 35 calls will be covered by your long stock. Your ownership of 500 shares matches the 10 short Feb. 35 calls exactly when they are coupled with your long Feb 30 calls. This is where exact volume construction becomes important.
Once stock trades through $35.00 we are in win – win situation and maximum return is guaranteed.
Tags: fix stock price, options reactions of up, stock repair strategy
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