THE AMAZING STOCK REPAIR STRATEGY

Bonus #2

THE AMAZING STOCK REPAIR STRATEGY In today s markets, everyone from amateurs to professionals alike experience losses sometimes. Since the bubble burst, investors have come to understand that managing losses is just as important as attaining profits. We have all found ourselves in situations where we have purchased stock that proceeded to trade down leaving us with a loss or a losing position that we had to fix. During the recent bull market, a common solution was to buy more of the stock at its lower price and wait for it to go up. This strategy of buying more is called doubling down. This is a risky strategy and not what we recommend, but let s review it anyway. Doubling down allows investors to lower their dollar cost per share so that the stock only has to gain back a portion of the loss to reach break even. For example, let's say you purchased 500 shares of XYZ stock (XYZ) for $40.00 per share. Your capital layout would be $20,000. (Commission costs, which vary greatly, are not included in our calculations of stock transactions but should be included when you figure your bottom line.) Now let s suppose that the stock immediately dropped down to $30.00 per share. You would have a $5,000 loss on your investment. In order for you to recoup your $5,000 loss, the stock would have to trade back to $40.00. The doubling down strategy would have you buy another 500 shares at $30.00 which would give you a total of 1000 shares. (500 shares purchased at $40.00 and another 500 shares at $30.00). This would produce an average purchase price of $35.00 per share on 1000 shares, and is known as dollar cost averaging. With the stock at $30.00, you are now only $5.00 away from being even instead of $10.00 away. This is because you now own 1000 shares at an average price of $35.00. 1

With this position, the stock would only have to trade back up to $35.00 for you to break even instead of the stock having to trade all the way back to $40.00. However, if the stock did trade back up to $40.00, you would see a profit of $5.00 per share on 1000 shares, for a $5,000 profit. This strategy worked very well during the bull market and for years, many investors made large sums of money buying the dips and doubling down. In the table below, let s assume that we purchased the stock at $40, as in our example above, and then purchased additional shares at the new stock price. Original Purchase Price DOUBLING DOWN STRATEGY RESULTS (Per Share) Current Original # Original Additional Stock of Shares Stock Shares Price Purchased P & L Purchased P & L of New Purchase Total P & L Per Share $40.00 $25.00 500 $-15.00 500 $-5.00 $-20.00 $40.00 $30.00 500 $-10.00 500 $0.00 $-10.00 $40.00 $32.00 500 $-8.00 500 $+2.00 $-6.00 $40.00 $35.00 500 $-5.00 500 $+5.00 $0.00 $40.00 $37.00 500 $-3.00 500 $+7.00 $+4.00 $40.00 $39.00 500 $-1.00 500 $+9.00 $+8.00 $40.00 $40.00 500 $0.00 500 $+10.00 $+10.00 $40.00 $42.00 500 $+2.00 500 $+12.00 $+14.00 $40.00 $45.00 500 $+5.00 500 $+15.00 $+20.00 When the bubble burst, the greatest weakness of this strategy was exposed. When you double down, you are doubling your position to average down your dollar cost per share. However, along with the doubling of your position comes the doubling of your risk. The strategy works well when your stock rebounds, but not so well if the stock price continues going lower. Once the bubble burst, many investors not only felt the sting of not being able to recoup their initial loss, but got hit with additional losses after they "doubled down" and their stock continued to trade down. Let's look back at our example. Above, we purchased 500 shares of XYZ for $40.00 and the stock traded down to $30.00 leaving us with a $5,000 loss. We then purchased 500 more shares in a double down strategy to lower our average cost. We now own 1000 shares at an average cost of $35.00. Now let s say that instead of the stock rebounding, the stock continues to fall to $25.00. The original purchase of XYZ at $40.00 has netted us a $15.00 per share loss for a total dollar loss of $7,500. But we also have to account for the additional 500 shares we 2

bought at $30.00. This amounts to a $5.00 per share loss on 500 shares for an additional loss of $2,500. This brings our total loss to $10,000! As you can see, doubling down doubles your position both on the way up and on the way down. It can help eradicate losses but can just as quickly multiply them. So what can an investor do? Introducing the Amazing Stock Repair Strategy. This strategy involves buying one atthe-money call option while simultaneously selling two out-of-the-money call options on the same stock, in the same month. The construction of this trade is critical. First, you must make sure to purchase exactly the equivalent amount of at-the-money call options as shares of stock you own. Remember, each option contract is worth 100 shares. So if you own 500 shares, then you would purchase 5 at-the-money calls. If you owned 3000 shares then you would purchase 30 at-the-money calls. Now that you have purchased the correct and exact amount of at-the-money calls, you then must sell exactly twice the amount of out-of-the-money calls. Again, it is imperative that you sell exactly two times the amount of out-of-the-money calls as the amount of atthe-money calls you own. Looking at the case in which you owned 500 shares and bought 5 at-the-money calls, you would then have to sell 10 out-of-the-money calls to properly construct the Stock Repair Strategy. Likewise, in the case where you owned 3000 shares and bought 30 at-themoney calls, you would then have to sell 60 out-of-the-money calls for proper Stock Repair Strategy construction. Here s why. The 500 shares of stock you have, along with the 5 call options you just bought, will result in an even spread trade. The reason this is important is because without owning the equivalent of 10 calls (or 1000 shares of the underlying stock), then the 10 out of the money calls you sell would be considered naked and may require an additional margin requirement. Selling naked calls is considered risky. However, by owning 1000 shares of stock (or 10 call options) at a lower price, your risk is limited because your sold calls are considered covered. 3

The chart below shows some examples of the correct Stock Repair Strategy ratios. Stock Repair Strategy Ratio Shares owned At-the-money-calls purchased Out-of-the-money calls sold 500 5 10 1000 10 20 1500 15 30 3000 30 60 5000 50 100 10000 100 200 The total dollar value of the options' trade should be neutral or very close to neutral. In this way, you can establish the position without putting out any more money or at least very little. In some cases, you can even put on this trade for a credit, whereby you can sell the out of the money calls for more than you paid for the at the money calls. This scenario is ideal, because then you also profit from this part of the trade also known as a credit spread. (Remember, you will be selling the out of the money calls in a 2:1 ratio to the at the money calls you purchase.) The out of the money calls will invariably be cheaper than the calls you buy, but the 2:1 ratio makes up for the difference in pricing. The easiest way to explain this is by example. Again, we will go back to our XYZ example. You have purchased 500 shares of XYZ for $40.00. The stock then trades down to $30.00 leaving you with a $5,000 loss. At this point, at $30.00, you would construct the Stock Repair Strategy. (Option prices are for example purposes only.) You would buy 5 February 30 calls for $1.50 and sell 10 February 35 calls for $.75 each. This strategy is known as a 1 by 2 spread. Now that the position is in place, you are long 500 shares of XYZ, long 5 February 30 calls and short 10 February 35 calls. Just to clarify, if you were long 1000 shares of stock, then you would also be long 10 February 30 calls, and short 20 February 35 calls. Remember, the ratio of stock, to purchased calls, to sold calls is 1:1:2. Let's look at how the options will react in the three scenarios: up, down, and stagnant. Remember, we have entered this trade already down $5,000 from the stock purchase. If the stock continued to trade down, the option position would produce no additional loss. Because it didn t cost you anything (ideally) to initiate this strategy, you will not lose anything additional on the spread as the stock trades down further. 4

This is a major advantage over doubling down, because the spread cannot add to the existing losses of the stock position. With the stock trading down and closing below $30.00, the February 30 calls and the Feb. 35 calls will both expire worthless. Since the cost of construction of the stock repair strategy didn t cost you anything (in our example), and the trade is now worthless, then you haven t lost anything additional. Although your stock position will continue to lose, it will not be compounded by doubling your stock position or doubling down. If the stock stays stagnant and closes at $30.00, again the position will not make or lose anything additional. With the stock at $30.00, both the February 30 calls and the February 35 calls will expire worthless. The up scenario is where the stock repair strategy is really powerful. The best way to see how this strategy works on the upside is to fix the 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. This gives the 1 by 2 spread a value of $1.00. You purchased the spread for even money so you now have a $1.00 profit on the spread. Meanwhile, since you still own the stock, it is also up $1.00. So, with this $1.00 movement, you have recovered $2.00 of your losses back. This continues to work this way as the stock rises up to $35.00. At $35.00, the Feb. 35 calls will still have no intrinsic value, therefore the 1 x 2 spread which you own is now worth $5.00. At this moment, with the stock recovering from $30.00 to $35.00 and the spread earning $5.00, you are now even in your overall position. You had originally lost $10.00 on the stock trading down from $40.00 to $30.00. Now, with the help of the Stock Repair Strategy (1 x 2 spread) you have made your loss back on a 50% retracement bounce from the original loss ($40 -> $30 -> $35) without having to take on any additional risk, 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 trades over 35, the Feb. 35 calls become in-the-money and have value. As the stock continues up the Feb 35 calls will start to outpace the 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. Remember, you still own 500 shares of XYZ. No matter how much higher above $35.00 the stock goes, each of the Feb. 35 calls is covered. Five are 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 are covered by your long stock. You own 500 shares and that matches the 10 short Feb. 35 calls exactly when coupled with your long Feb 30 calls. This is why the exact volume construction we talked about earlier is so important. 5

Therefore, after the stock trades through $35.00 the positions maximum return is locked. Below is a profit and loss chart showing how this Stock Repair Strategy works at different stock price levels. The chart will show the stock price, the price of both the Feb. 30 and Feb 35 calls, the individual profit and losses of the stock and the options and finally a profit/loss of the entire position, assuming the original stock purchase price was $40. Current Stock Price Stock P&L STOCK REPAIR STRATEGY RESULTS Feb. 30 Feb. 35 Feb. 30 Feb. 35 Option Option P & L P & L Price Price Total Option P & L Total Position P & L $25-15.00 0 0 0 0 0-15.00 $27-13.00 0 0 0 0 0-13.00 $28-12.00 0 0 0 0 0-12.00 $29-11.00 0 0 0 0 0-11.00 $30-10.00 0 0 0 0 0-10.00 $31-9.00 1.00 0 +1.00 0 +1.00-8.00 $32-8.00 2.00 0 +2.00 0 +2.00-6.00 $33-7.00 3.00 0 +3.00 0 +3.00-4.00 $34-6.00 4.00 0 +4.00 0 +4.00-2.00 $35-5.00 5.00 0 +5.00 0 +5.00 0 $36-4.00 6.00 1.00 +6.00-2.00 +4.00 0 $37-3.00 7.00 2.00 +7.00-4.00 +3.00 0 $40 0 10.00 5.00 +10.00-10.00 0 0 $42 +2.00 12.00 7.00 +12.00-14.00-2.00 0 $45 +5.00 15.00 10.00 +15.00-20.00-5.00 0 $50 +10.00 20.00 15.00 +20.00-30.00-10.00 0 As you can see from the chart, the Stock Repair Strategy will get your position back to even at the same place as doubling down would have, and in half of the move required to recover your losses by just holding onto the stock. In our example, the prices are constructed to make the calculations easier and to work out so that the trade incurs no debit or credit. As mentioned previously, it is not often that the numbers work out this evenly. Ideally, this 1 x 2 spread will be purchased for a credit; that is you will receive a little profit up front by doing the trade. It will not be much, but this credit (profit) should be factored into your return. If you can t get the spread for a net credit, it is important to note that the closer to even that the trade sets up for, the better result you will see from the trade. Remember, since the trade will be very close to even to begin with, it is only important to note that the closer the trade is to even, the better unless you can put it on for a credit. 6

Conclusion: The goal here is to try to make back the money lost without the stock having to trade all the way back to the original level. Doubling down (also known as Dollar Cost Averaging ) does accomplish this but you must have substantial additional funds to cover another stock purchase and you must be aware that you now have twice the size of the position thus twice the risk if the stock continues to trade down. This can translate into even larger losses on continued downward movements. Also note that Stock Repair works best on more volatile stocks trading in wide intraday ranges, because the volatilities will be higher so you can generally sell the out of the money calls for more money. It also works best on a stock that recently declined rapidly, and lost 10 25% of it s value unexpectedly, because here you would most likely expect to see some degree of technical bounce. Generally, you would also be able to receive higher premiums from selling the out of the money calls while volatilities are high, to offset more of the cost of the at the money calls you would purchase. Knowing this, the Stock Repair Strategy, alleviates the two major risks of the Doubling Down Strategy while still allowing for recapturing losses in less of a move if the stock rebounds. First, the reason we buy one option and sell two is so that we do not have to put up additional capital, as you would have to when doubling down. You may have to put out a small amount of money if the 1 by 2 spread produces a debit, but it will be pennies on the dollar compared to another stock purchase, plus commission costs. Second, the Stock Repair Strategy allows an investor to recover from a loss with less of an upward move in stock price. So, next time a stock that you own trades down sharply, in a short amount of time, take a look at the option premiums and see if the Stock Repair Strategy might work for you. 7