No matter how much research you do, some trades don’t work out as planned. It doesn’t matter if you’re new to the markets or have been trading for decades like me.
As painful as it is, sometimes you need to cut your losses and move on to your next trade – especially if the rationale for the trade no longer holds up.
But sometimes things aren’t clear-cut…
What if you believe the stock could recover at least a portion of your loss?
Some folks average down on their stock position… In other words, they keep buying when the stock goes down. That lowers their average entry price (and breakeven point).
But that can be a costly mistake. You can end up with huge losses if the stock price keeps falling to new lows.
So what’s the alternative?
One solution is an options strategy that I’d like to share today. It can recoup your losses even if the stock doesn’t return to your original entry price.
Let’s see how you do it…
To understand the strategy, let’s consider an example where you bought 100 shares of a stock at $200. But after buying those shares, the price tumbles to $100.
As I mentioned above, if the reasons you bought those shares no longer exist, then you’re better off just cutting your losses.
However, if you believe the stock will recover, you have choices…
You could hold on in the hope that the stock gets all the way back up to $200. But that could take a long time… if it happens at all.
The riskier choice is to “average down” and buy another 100 shares at $100. That lowers your average entry price to $150. But now you own twice as many shares and have tied up more of your valuable capital. You’re even more vulnerable if the stock takes another leg down.
In contrast, consider the strategy we’re looking at today…
In this scenario, you decide to keep your original 100 shares that you bought at $200 a share.
Then you buy one call option with a strike price of $100 – that’s right around the current stock price.
Buying that call option gives you the right to buy 100 shares at $100 per share until the option expires.
If you exercise the option, you will own 200 shares. You would also lower your average entry price to $150 (similar to averaging down).
However, there’s a major difference…
That call option only costs you a fraction of buying more shares.
And a second leg to this strategy lowers your cost (and potentially hands you a credit)…
For the second leg, you sell two call option contracts at a $150 exercise price. You typically receive enough premium to cover the cost of buying the $100 strike call option contract.
So you shouldn’t be out of pocket to enter this trade.
Then, if the stock rises to $150 (or higher), the option buyer will likely exercise their contracts, and you’ll be out of the trade at breakeven.
(Remember, if you exercise your bought call option at the $100 strike, your breakeven becomes $150.)
It’s like a free hit. You reduce your breakeven on the original trade without committing additional capital.
If the stock stays around the current level (or falls), you’re no worse off than if you had just held your original 100 shares.
Yet if it recovers up to $150, you’re out of the trade without a loss.
As with all option strategies, you need to understand the risks and obligations…
Using our example, buying the $100 call option gives you the right (but not the obligation) to buy 100 shares at $100 per share right up until expiry.
However, selling two $150 call options means you must hand over 200 shares at $150 if the buyer exercises those options. That’s true even if the shares recover strongly and are trading much higher than $150.
Also, remember that options expire, so the clock is always counting down on your position. You have to get the recovery you’re expecting within a specific time frame.
And one more note: This strategy offers no protection if the stock price continues to slide below the $100 level.
But when you remain convinced that a stock could recover after a fall, this can be a very useful strategy. And unlike “averaging down,” it enables you to lower your breakeven without tying up additional capital.
Happy Trading,
Larry Benedict
Editor, Trading With Larry Benedict
Reading Trading With Larry Benedict will allow you to take a look into the mind of one of the market’s greatest traders. You’ll be able to recognize and take advantage of trends in the market in no time.
