- 2002: Volume 11, No. 1 Puts & Calls: Using Options to Recover From Post-Technical Stress

There's nothing more frustrating than being stuck in a losing position. You try not to think about it, but it is always on your mind. You keep hoping that things will change, but it usually gets worse more often than better. Your partners—fear and greed—are painstakingly badgering you until you finally bite the bullet and exit the trade. Any trader that has ventured into buying tech stocks earlier this year has experienced "sticker shock" from drops in the stock's value. Even with the recovery that is now eight weeks in the making, most traders and investors are still looking at their portfolio with sticker shock in their eyes. Stocks such as EMC, YHOO, and BRCM have made nice gains, but are still down staggering amounts from this time last year.

Let's face it: nobody wants to have a trade go against them (let alone, have to tell others about it). Most people, when faced with this dilemma, would rather wait out the bad times to avoid taking the loss. This alone could spell disaster, especially when the position goes from bad to worse. Maybe you're right; the trade will make a recovery. But wouldn't it be nice to average the trade down without adding any additional risk to the position? Using options, you can construct positions that bring the breakeven on the trade closer to today's price without adding any additional cost or risk to the position.

But first, let's take a look at the choices a trader has when faced with a losing position:

• Take the loss and move on. Very few traders are willing to accept defeat gracefully. Those who do may have changed their belief on the stock, and subsequently realized that thousands of other stocks out there are just waiting to be traded. Bottom line, you have to be a disciplined trader to take your losses and move on.
• Average down on the position. Averaging down by purchasing more shares at the current lower price is usually the first thing an undisciplined trader will do in an attempt to lower the breakeven on the position. For instance, buying 100 shares of Yahoo at 100, and later buying 100 shares of Yahoo at 50, would adjust the basis of the trade to 75. The problem here is that the risks of averaging down increase as you add to the position. This is true of options traders too, who average down on calls as the price drops. Averaging down only works on a falling stock as long as your bankroll can support it. Most people don't have that kind of luxury.
• The Religious Approach. Sad to say, but the majority of traders fall into this category. They take a position and then freeze like a deer in headlights as the trade goes against them. What is happening here is that not only are you hanging onto a position that you're not sure of in terms of its future; but you're also tying up money, that could be put to better use.
• Recovery Strategy Using Options. Spreading options against the stock can lower your breakeven on the position without adding more cost to it. Recovery strategies are a low-risk way of adjusting a position if you still feel it could move in your favor. But that's the key: you still need to believe that the stock will move up at least to where you originally purchased it.

Let's assume that the trader has purchased 100 shares of Yahoo (YHOO) several weeks ago for a cost of $30 per share (see Figure 1). Over time, the stock has depreciated to a price of $15 per share. The trader has a paper loss of approximately $15 per share on the stock.

Figure 1:

But by understanding how options work, a skilled trader can employ a recovery strategy using a call ratio spread against the stock. A call ratio spread consists of buying lower strike calls and selling higher strike calls. The ratio is created by selling more higher strike options than you buy. While this position alone has unlimited upside risk, employing it along with a long stock position will limit the upside risk, while lowering the breakeven on the trade. Entering it properly can also be done at no additional cost. Let's continue with our example using recent prices of YHOO.

Long 100 shares of YHOO at 30 Stock is now trading @ 15 Yahoo January 2004 15 calls @ 7.50 Yahoo October 2004 30 calls @ 3.75

Buying one of the January 2004 15 calls and selling two of the January 2004 30 calls creates what is called a covered call ratio spread. The cost of this spread is zero, since the two options sold pay for the one option that is bought. There is no margin on this trade because both of the short options are covered. Risk is limited because no matter how high the price of the stock rises, the stock will cover the extra call that is sold. The position's breakeven is also reduced; by option expiration, the breakeven on the trade is 22.50—7.50 points lower than the original purchase price of the stock. The only other way to lower your breakeven to 22.50 is to purchase an additional 100 shares of Yahoo at a price of 15, which ties up more money and at the same time, will double the downside risk. The table in Figure 2 shows the profit and loss of each position over different prices.

Figure 2

Trade	Original Trade		Average Down		Recovery Strategy
Price of YHOO	Value	Profit/Loss	Value	Profit/Loss	Value	Call value at Expiry	Profit/Loss
0 15 20 30 40	$0 $1,500 $2,000 $3,000 $4,000	-$3,000 -$1,500 -$1,000 $0 $1,000	$0 $1,500 $2,500 $4,500 $6,500	-$4,500 -$1,500 -$500 $4,000 $6,000	$0 $1,500 $2,000 $3,000 $4,000	$0 $0 $500 $1,500 $500	-$3,000 -$1,500 -$250 $750 $1,000

Looking at the table there are some things to consider. First and foremost, you have to believe that the stock in question will make some sort of recovery. Second, you must accept the fact that this trade has a limited reward. In this example, you lose the ability to participate in any profits above 30. If you are okay with both of these points, then a recovery strategy may be just what the doctor ordered.

Now it's time to take a good look at the positions you are currently trading. Although the market recovery is in progress, how likely is it that your stock will recover? Overall, by weighing the risks and rewards of each position, you'll see there are some clear advantages to using options as a "911 Strategy," especially to those injured positions just languishing away in your account.

Tom Gentile is the chief options strategist for Optionetics, an educational company dedicated to providing stock and options education fundamentals as well as strategies that enable traders to navigate the markets successfully. A highly acclaimed author, Tom leads numerous 2-day and 3-day Advanced Optionetics seminars teaching innovative options trading across the country. Comments and questions can be directed to Tom at optionetics@hotmail.com. Domestic Phone: (888) 366-8264 International Phone: (650) 802-0700 Fax: (650) 802-0900.

Web site: www.optionetics.com