By: Costas Bocelli — December 9, 2018
We've all been there...
That stock we thought couldn't miss falls 10%... 15%... 20%...
Even the mighty Apple Inc. (AAPL) hasn’t been immune from the stock market correct that began in early-October.
The stock has recently slipped into bear market territory (down more than 20%) from its record closing high of $232 per share on October 3rd.
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While we may have an unwavering belief in the company and its future prospects, we don't know how far it will fall. We only know we're getting more and more nervous.
Yet, we still like that stock. We did our due diligence. It could just be a temporary dip...
While it may seem reasonable to "sell now and ask questions later," the stock has pulled back from its peak, which makes its current valuation extremely attractive.
And even though the pit of your stomach says otherwise... selling now after such a significant price decline might not be your best option.
Maybe simply holding while the dust settles is more prudent, especially if, say, the fundamentals look solid, or the company pays a dividend like AAPL.
But what about the third option -- adding to your long position?
It might be the opportunity you’ve been looking for -- a chance to buy more shares on weakness, even if you have to take some bad news along with your added shares. But for me, and I’m guessing you as well, adding more exposure in the face of uncertainty and the Dow plunging hundreds of points earlier this week would feel too risky.
Is there another way to add bullish upside exposure -- right here, right now -- without taking on any more risk?
The answer is... yes!
There is a powerful technique for accomplishing exactly that. Once you learn this strategy, you'll be able to apply it to most listed securities.
It’s basically a "repair strategy," and it comes in especially handy during market downturns like were experiencing now.
This repair strategy harnesses everything that’s great about options, and takes advantage of their benefits.
It’s called a Ratio Vertical Spread.
Don’t let the complicated name fool you. The strategy is quite simple and easy to learn. It's particularly useful when a long stock position has sold off like AAPL, but you still feel good about holding onto it in hopes of a rebound.
It’s designed to give your stock position added upside potential, like a mini turbo charge. Best of all, the technique carries minimal risk and, if structured properly, it can be put on for free or at a very minimal cost (in some cases, you can get paid for extra upside potential).
The best part: It does not add any additional downside risk other than what you already have on your existing stock position!
When used as a repair strategy for a long stock position, the ratio vertical spread simply entails buying ONE slightly out-of-the-money Call and selling TWO higher strike out-of-the-money Calls against it.
You’ll want to do this in the same expiration date (preferably 3-6 months out) while maintaining the proper ratio. The proper ratio is: For every 100 shares of long stock you wish to repair, you buy one Call option at the lower strike and sell two Call options at the higher strike.
That essentially leaves you with a bull call vertical spread, plus an added higher-strike call contract which you've sold. Even though you’re short that extra call contract, you’re still completely covered by the long stock position. You’re truly hedged.
In the case of AAPL, for every 100 shares of stock held, you could look to buy One April 185 Call and sell Two April 200 Calls to create the ratio vertical spread. With the stock recently trading around $177, the trade can be purchased for even money, or no additional cost, to gain the leverage.
What this essentially does is give you additional upside potential (although limited) virtually for free, because you finance the vertical spread cost by selling that extra Call contract.
The idea is that if the stock does indeed recover and trade higher, the option structure will act like a double stock position in between the two option strikes, magnifying your gains.
If this result materializes, you’ll find that your repair strategy has made up a great deal of your previous losses, with a smaller move in the underlying stock price.
Ideally, you’ll want the stock to trade above the short call strike, which is your maximum profit gain and likely your position exit. At that point, not only have you picked up all the gains from the long stock position, but you’ll pick up the difference between the two option strikes for an additional gain.
If the stock does not rally back up... well, then you’ll essentially be in the same boat. But you'll have incurred no additional losses from the option trade, because you’ll have laid out nothing to buy the 1x2 ratio spread.
You will face an opportunity cost. Should the stock continue even higher, beyond the higher strike where you sold the Calls, your gains will be capped at that point and your stock position will be called away.
But hey, remember: This is a repair strategy. You use it when you've already been stung pretty good. So, my feeling is at the time you put this technique to use, you'll be more than happy with the result.
The bottom line is that options can benefit you greatly, and they offer investors tremendous advantages. The key is to make sure you use them properly and for the intended reasons.