Implementing a Call Ratio Repair Strategy
By Joel Addison, Optionetics.com
02/12/2001 5:00:00 PM
I think I'm safe in stating that many of us have watched a blue chip stock or other long-term holding fall in value over the last 6-months. Many feelings go through an investor's mind when this happens, including anger and a lot of crying. The investor can view the holding in different ways. One would be to just hold on and pray the stock comes back; but this strategy doesn't always solve the problem. Another strategy-equally popular, but more reliable-is to double down which is accomplished by doubling your position by purchasing more shares at the lower price. Although it can be a successful way to lower your breakeven point, it also doubles the amount of money at risk in this single position. Let's take a look at a third alternative: the use of a repair strategy using options called a call ratio spread.
In order to see this strategy in action, let's use a hypothetical example. Let's say you purchased XYZ stock at $100 and it has since fallen to $80. You have three options: just hold on, double down, or implement a call ratio spread repair strategy. Assuming you purchased 100 shares, your $10,000 initial purchase is now worth only $8000-a loss of $2,000.
To understand how and why this strategy could be the best choice, let's take a close look at the basics of a call ratio spread. First of all, a call ratio spread should only be used if you are still somewhat bullish on the stock. If you are not, take the loss and get out. All three of our possible strategies assume a bullish bias. A call ratio spread involves buying an at-the-money call and selling two higher out-of-the-money calls. This should be done as close to a zero cost as possible. Doing this without owning the underlying would result in a strategy with unlimited risk on one of the short calls, but by purchasing one call and owning 100 shares of the underlying stock, you are setting up a limited risk position.
Let's say you buy the $80 call at $5 and sell the two $100 calls at $2.50 each, then the spread is essentially free (not including commission costs). The result is a breakeven point halfway between the current price and the initial price of the shares. Let's take a look at our breakeven points for each of these three alternatives.
Hold On - Breakeven is $100
Double Down - Breakeven is now $90, but you had to put out an additional $8000 to purchase another 100 shares of stock at $80.
Call Ratio Spread - Breakeven is now $90 without any extra money put to work. This strategy does limit our upside potential though.
Let's think about it. When you are down 20-50% on a stock purchase, are you looking for a profit or just hoping to get out without losing your shirt, spouse, kids etc? If you were still hoping for a long-term move well above the purchase price, then holding on to the stock or doubling down would be the better choices. But if you want to salvage a losing trade without needing to spend more money while lowering your breakeven, then a call ratio spread is ideal. Let me list the important things to remember on this strategy.
Buy one call at-the-money for every 100 shares of stock owned.
Sell two calls at the strike price closest to the original share price when purchased.
Use the closest month to expiration that allows for the spread to be placed at no cost or a slight credit.
Now, let's use a recent example to illustrate this strategy. If you had purchased 100 shares Network Appliance (NTAP) at $60 a few week's back, you would be sitting on a 33% loss right now. NTAP closed trading today at $39.13. So in order to use our call ratio spread strategy, you have to start by looking at the options. Going out to September, we see that the 40 Call has an ask price of $13.13 and the 60 Calls are bidding $6.25. Using these values basically leave you with a zero cost trade.
The best-case scenario would be for NTAP to return to $60 in September. This would allow the maximum return on your position. The two short calls would expire worthless, with the 40 Call worth around $20-a gain of $2,000 on the initial investment of $6,000. This would be a 33% gain even though the stock has not traded above your purchase price. More importantly, your breakeven price becomes just $50, instead of $60 if you just held on and prayed for a recovery. However there is one negative to this situation: if the stock continues to rise above $60, your upside potential is capped. But again, this strategy is a repair strategy at no up front cost.
No trader likes to be in a losing position; but the fact is it happens alot more than we's like to admit. How we react to this negative situation can have a big impact on the future value of our account. A call ratio strategy isn't always the best strategy to implement, but it does offer a clever alternative that can help out in many circumstances. |
