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Chapter 4 Averaging Through Derivative Instruments

Stock Option Repair Strategy

What is Stock Repair strategy?

As the name suggests, Stock Repair strategy is an alternative strategy to recover from loss that a stock has suffered due to fall in price. The Stock Repair strategy helps in recovering losses with just a moderate rise in the price of the underlying stock.

Why to Initiate Stock Repair strategy?

Stock Repair strategy is initiated to recover from the losses and exit from loss making position at breakeven of the underlying stock.

Who can initiate Stock Repair strategy?

A Stock Repair strategy should be implemented by investors who are looking forward to average their position by buying additional stocks in cash when the underlying stock price is falling. Instead of buying additional stock in cash one can apply stock repair strategy.

When to initiate Stock Repair strategy?

A Stock Repair strategy should be initiated only when the stock that you are holding in your portfolio has corrected by 10-20% and only if you think that the underlying stock will rise moderately in near term.

Let’s try to understand with an example:

DISHTV earlier Bought at Rs100
Quantity bought7000
DISHTV Current spot price (Rs)100
DISHTV earlier Bought at Rs90
Buy 1 ATM Call of strike price (Rs)90
Premium paid (Rs)5
Sell 2 OTM Call of strike price (Rs)100
OTM call price per lot (Rs)2
Premium received (Rs) (2*2)4
Break even95.5
Lot Size7000
Net Premium paid (Rs)1

For example, an investor A, had bought 7,000 shares of DISHTV at Rs100 in April, but the price of DISHTV has declined to Rs90, resulting in to notional loss of Rs70,000. A thinks that price will rise from this level, so rather than doubling the quantity at current price, here he can initiate the Stock Repair strategy. This can be initiated by buying one May 90 call for Rs5 and selling two May 100 call for Rs2 each. The net debit paid to enter this spread is Rs1 amounting to Rs7,000, which will be the maximum loss from repair strategy that A will face if DISHTV falls below Rs90.

If DISHTV expires at Rs80 level, then both the calls would expire worthless, resulting in loss of the debit paid of Rs7,000, as the net cost to initiate Stock Repair strategy is Rs1 per lot. Had A doubled his position at Rs90 level, then he would have lost Rs70,000 (10*7000). This shows he is much better off by applying this strategy.

If DISHTV expires at Rs100 then this would be the best case scenario where maximum profit will be achieved. May 90 call bought would result in to profit of Rs5, whereas May 100 call sold will expire worthless resulting in to gain of Rs4. Net gain would be Rs63,000 (9*7000).

Following are the two scenarios assuming A has implemented the Stock Repair strategy, whereas B has doubled his position at lower level. For the ease of understanding, we did not take into account commission charges.

Stock Repair Normal Averaging
DISHTV expires at Payoff from stock holding at Rs 100 Payoff from Repair Strategy Net payoff of Mr. A Payoff from stock holding at Rs 100 Doubling down position payoff Net Payoff of Mr. B
70 (2,10,000) 7,000 (2,17,000) (2,10,000) (1,40,000) (3,50,000)
80 (1,40,000) 7,000 (1,47,000) (1,40,000) (70,000) (2,10,000)
90 (70,000) 7000 (77000) (70,000) 0 (70,000)
100 0 63,000 63,000 0 70,000 70,000
110 70,000 (7,000) 63,000 70,000 1,40,000 2,10,000

Comparison:

A initiated stock repair strategy B Doubled his position at lower level
Margin Only margin money is required to initiate stock repair strategy Full amount has to be paid in cash for taking delivery of stock
Interest Loss (1 month) 1,50,000*0.08/12=1000 630000*0.08/12= 4200
Risk Risk associated is limited It involves high risk when the stock price falls
Brokerage Brokerage in Options is comparatively less. Brokerage paid to initiate position is higher as compared to Options.

The Payoff chart:

Analysis of Stock Repair strategy:

The Stock Repair strategy is suitable for an investor who is holding a losing stock and wants to reduce breakeven at very little or no cost. This strategy helps in minimizing the loss at very low cost as compared to “Doubling Down” of position.

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