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Special Report — Summer 2009 TM

David Gardner &


Options 601: Stock Repair
Jeff Fischer How to unload your losers at breakeven
Motley Fool Pro
At some point, we all get stuck holding a stock that has declined 20% and seems
unlikely ever to recover. This guide will show you how to use options in a safe
and strategic way to unload your losers at breakeven. My “stock repair” option
David Gardner is co-founder of The
strategy not only helps you recoup your initial investment, it frees up cash for
Motley Fool and co-advisor with Jeff new, better opportunities.
Fischer at Motley Fool PRO. Who should attempt this stock repair strategy? Any investor who is:

Jeff Fischer wrote Investing Without


• Down 15% to 25% on a stock and willing to forgo profits to sell at
a Silver Spoon and served as editor breakeven.
of several other Motley Fool best- • Not interested in averaging down or holding for the long haul.
sellers. He co-managed the original
Fool Portfolio (with Tom and David • Using a margin-approved account and can write call options.
Gardner) as well as the Rule Breaker
Portfolio, and recently returned as the Before we move on, a reality check: Stock repair does not protect you from ad-
advisor of Motley Fool PRO. ditional downside in the shares you already own. Nor does it offer you a profit
above your break-even price. The strategy can, however, lower your cost basis
Motley Fool PRO is a $1 million real- in a losing stock and allow you to exit the position at breakeven without intro-
money portfolio that leverages data ducing any additional risk.
from Motley Fool CAPS to invest in
the market’s best opportunities, using Setting It Up
stocks, options and ETFs. Motley Fool
PRO will begin enrolling new mem- To set up a stock repair, simply follow these steps. For every 100 shares of a
bers on June 16. losing stock you own …
1. Buy one call option -- giving you the right to buy 100 shares at a strike
price below the current share price.
2. Sell (write) two call options -- each obliging you to sell 100 shares at a
strike price above the current share price.
It is important that you use the same expiration date for the options you buy and
sell. And you’ll typically want to choose options that expire in 90 days or less.
The strategy does not bring new risk to your stock -- your options are neutral
and covered. Moreover, because your call options are paid for with the pro-
ceeds from the two call options you sell, these trades require minimal or no
cash outlay.
Specifically, the first of the two call options you sell is “covered” by the 100
shares of stock you already own. The second call option you sell is “covered”
by the new call you just bought. This sounds more complicated than it is, so
let’s turn to an example to show how it works.

Repair That Dog!


Assume you purchased 100 shares of a stock at $40 per share, and it now
trades at $30. You’re down 25%, lack hope for the stock’s recovery, and don’t
want to hold your shares any longer. At the same time, you don’t believe
there’s a great deal of downside risk left in the stock So, in another example, if you bought 100 shares of a stock
-- otherwise, you’d simply sell. Your best move to get to at $50 that has since fallen to $40, to repair it, you’d buy
breakeven is to initiate a stock repair strategy. one $40 call and write two $45 calls.
To start, you purchase a call option to buy 100 shares $30 Pro Bottom Line on Stock Repair
that expires in 60 days (cost $2.50). You then sell two $35
When you’re down a reasonable amount on a lagging stock
call options for $1.25 each. Your option trades have paid
and simply want out at breakeven, setting up a stock repair
for themselves. Your positions look like this:
strategy may help you meet your goal more quickly. The
• Original stock, bought at $40, is now $30 strategy does not increase or decrease your risk in owning
the stock, but (unless you close the options early) it does
• Buy one $30 call option costing $2.50
limit your upside to your breakeven price.
• Sell two $35 call options for $2.50 total income
In return, you must be content to just breakeven and con-
Here are your possible outcomes: fident the stock won’t fall sharply while you wait. If you’d
like to learn more about this and other options strategies,
IF the $30 find out more about Motley Fool PRO.
stock... THEN...
Jeff Fischer and David Gardner are managing $1 million in
Declines or holds All the options expire, nothing changes (you just
steady at $30 lost on commissions). You can try again. Motley Fool company funds in a portfolio of stocks, shorts,
You make $2.50 per share on your $30 call option
options, ETFs, and other investment strategies. A small
(because you bought it for $0 net cost) and by number of investors will be invited to look on in real time.
Ticks up a few dol- selling the call for the gain, you’ve effectively
lars -- say, to $32.50 lowered your stock’s cost basis to $37.50. The
The project is called Motley Fool PRO, and will enroll a
calls you wrote expire worthless. You can use the limited number of new members on June 16, 2009. If you
strategy again. would like to learn more and be notified when Motley Fool
Your $30 call is now worth $5 per share, all profit, PRO opens, watch your inbox on June 16.
Recovers to $35 so your cost basis in the stock is now $35. You
-- bingo! can sell or close all positions and break even
(commissions aside).
No problem. You are breakeven on the stock, and
Soars to $40 your options cancel each other out. You can close
everything and move on.
All of your positions still cancel each other out,
Catapults beyond
and you can still sell your stock at breakeven.
$40
You’ve forgone a profit in the stock, though.

As you can see, the stock repair strategy has three possible
outcomes: (1) no effect at all if the stock doesn’t move or
declines; (2) a lower cost basis if the stock ticks up; or (3) a
break-even sale if the stock cooperates even halfway.
But what if you set up a stock repair trade only to change
your mind and turn bullish on your stock again? The situ-
ation is salvageable. Let’s say your stock returns to $40 on
good news, and you wish to keep owning it. In that case,
you can close all of your option trades at or near breakeven
(they’ll largely cancel each other out) and continue to hold
the stock.

Choosing Your Strike Prices


In general, this strategy works best when you’re down
about 20% on a stock. You buy your lower-priced call op-
tions at a strike price that is about 20% below your original
purchase price (or, at about the current share price). You
sell your two call options at the midway point between the
current share price and your original purchase price, split-
ting the two.

2 Motley Fool Pro Special Report — Spring 2009