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Tuesday, March 27, 2012

Repair a Call Option by Rolling to a Debit Call Spread

Many times you buy a long call and the underlying stock moves lower. The stock now needs to move up even more than initially and has less time to do so. Your position starts losing money and you can basically exit for a loss, or stay in the trade hoping for the best. Another alternative is to lower your breakeven point if you think there are good chances for the stock to go up. This can be done by getting out of your current position and entering a Bull Call Spread.

With XYZ at $100, you bought a 2-month $100 Call for $5.00. Breakeven at $105.00. That's the price of the stock at which you won't lose money at expiration.

A few days later, XYZ is trading at $97 and your $100 Call is now worth $3.00. XYZ now has to move 8 points to reach your breakeven point and there is less time to expiration. You feel that XYZ is more likely to go up now, but not as much as 8 points anymore.

You decide to stay long, but lower your breakeven so chances are higher that you can make a profit.
This is how it works:

Suppose that the $95 Call is worth $5.00 ($2 in the money plus $3 in time value)
You can exit your $100 Call by selling it for the $3.00 it is now worth, and sell another extra $100 Call for $3.00 more. You are now net short one $100 strike Call. And you also purchase a $95 Call for $5.00.

Initial position
Long one 100 strike Call at $5.00 (This Call loses $2.00 and goes down to $3.00)

Sell two 100 strike Calls at $3.00 (Total credit $6.00)
Buy one 95 strike Call at $5.00
The whole transaction is executed for a net Credit of $1.00, which partially offsets the loss on the initial 100 strike Call which had lost value from $5.00 all the way down to $3.00.

Final position
Long one 95 strike Call and Short one 100 strike Call, which forms a Bull Call Spread position.

As a result, you are now playing a 95/100 Bull Call Spread, you have a locked in loss of $1.00 (2.00 lost on the first Call but 1.00 recovered during the adjustment). However, the interesting part is that the new breakeven point now sits at 95 + 5.00 - 3.00 = 97.00. Meaning you have drastically reduced your breakeven point from 105 to 97 and therefore increased the chances of winning by expiration. At the same time you reduced your temporary $2.00 loss to a permanent one of $1.00 and that's essentially the consequence of doing this adjustment, you lock in a loss.

The new maximum risk is $200 (difference between prices of the 95 strike ($5.00) and the 100 strike ($3.00) multiplied by a hundred.

You went from having an initial maximum risk of $500, breakeven point 105, and temporary loss $200, to a new position where your maximum risk is $200, breakeven point 97 and a locked in loss of $100.

Obviously, the same technique can be applied with Puts in the event you trade a Put and the stock goes against you by moving up. You can sell twice the number of Puts and by another one at a higher strike price resulting in a Bear Put Spread. Where you improve your breakeven point giving you higher chances of a profitable trade and at the same time your maximum risk is reduced.

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  1. Dear Henrik,
    I read many advise from your post and you're the best.

  2. Thanks for your words man! Good to have you as a reader