In the part one, I shared a very powerful strategy to repair your stocks using the Cash Secured Put.
If you haven’t read part one, you can do so here: Stock Repair Strategy (Part 1)
In this part two, I will share with you two more powerful stock repair strategies.
Are you ready?
Let’s begin!
Stock Repair Strategy #2: Put Ratio Spread
So what is the Put Ratio Spread?
It simply means to buy one Put Option and sell two Put Options as shown in the image below.
The Long Put Option is usually At-The-Money (ATM) or slightly Out-of-The-Money (OTM).
As for the Short Put Options, they are further OTM below the Long Put Option.
The term “ratio” comes from the difference in the number of Long Put Option and Short Put Options.
So in this case, the ratio is 1:2.
This ratio can be changed as you like, as long as the Short Put Options are more than the Long Put Options.
For example, the ratio can be 1:3, 2:3, or any denomination that gives you an overall credit for the Put Ratio Spread.
However, with every additional Short Put Option that you have, your risk also increases.
To make things easier, we generally want to stick to the 1:2 ratio.
And the better way to look at the Put Ratio Spread is that it consists of two Option strategies:
- Bear Put Spread (Debit Vertical Spread)
- Cash Secured Put (Credit)
Since we will receive a credit for selling the Cash Secured Put and we pay a debit for buying the Bear Put Spread…
We want the credit from the Case Secured Put to be more than the debit of the Bear Put Spread.
This way the Bear Put Spread is essentially free!
And we can even receive a net credit from selling the Put Ratio Spread as a whole.
For example, if the Bear Put Spread costs $2.00 and the credit received from the Cash Secured Put is $2.50, our net credit would be $0.50.
We have fully financed the purchase of the Bear Put Spread with the Cash Secured Put, and we still have an extra $0.50 on top of it that we get to keep!
Now, by seeing the Put Ratio Spread as two Option strategies, we are able to understand the purpose of the Put Ratio Spread.
Let’s start with the Bear Put Spread.
The Bear Put Spread is a bearish Options strategy.
That means we want the stock to go down.
And if the stock goes below the Short strike of the Bear Put Spread, we make the full profit of the Bear Put Spread.
Once we’ve taken the full profit of the Bear Put Spread, we are left with the Cash Secured Put.
And because the stock is below the strike price of the Cash Secured Put at expiration, it is exercised and we are assigned 100 shares of the underlying stock.
Now, let’s take a look at a visual illustration to see how the Put Ratio Spread actually works.
This is the chart of Disney (Ticker: DIS).
Imagine that you’re already Long 100 shares at $110.
And you’ve decided to sell a Put Ratio Spread, as a stock repair strategy, with the strikes of 92/85 for a net credit of $0.05.
That means you’ve pocketed $5 for it.
Let’s take a look at a few scenarios that can happen.
Scenario #1: Disney is above $92 at expiration.
If Disney is above $92 at expiration, then your Put Ratio Spread expires worthless.
And you get to keep the $5 you received as premium.
This makes your average cost:
$110 – $0.05 = $109.95
Not too bad.
At least you didn’t lose money!
Scenario #2: Disney is in between $92 to $85 at expiration.
If Disney is in between $92 to $85 at expiration, it means you made money on your Bear Put Spread.
How much you made is dependent on where it actually closes at upon expiration.
For example, if it closes at $90, then the profit from the Bear Put Spread is:
$92 – $90 = $2.00
So the total profit would be $2.05, including the $0.05 credit you got at the start.
This makes the average price:
$110 – $2.05 = $107.95
That’s not bad!
Now, what if Disney closes at $87 instead?
Then the profit from the Bear Put Spread would be:
$92 – $87 = $5.00
Thus the total profit would be $5.05.
And the average price would become:
$110 – $5.05 = $104.95
This is better!
So what then happens to the Cash Secured Put?
It expires worthless!
That means you didn’t get Long another 100 shares and you can sell another Put Ratio Spread!
And if the next time you sell the Put Ratio Spread and you make money on the Bear Put Spread but the Cash Secured Put expires worthless again…
You can keep selling the Put Ratio Spread over and over again to keep collecting profits to reduce the average cost of your stock!
Now, what happens if Disney closes below $85?
Scenario 3: Disney closes below $85 at expiration.
In this case, it’s actually even better.
You will make the full profit on the Bear Put Spread, which is:
$92 – $85 = $7.00
And the total profit would be $7.05 including the $0.05 premium received at the start.
But what about the average price?
The average price is now significantly lower because your Cash Secured Put got exercised and you’re now Long another 100 shares!
So let’s calculate the average price of your stock after getting Long another 100 shares at $85 and accounting for the profits received:
($110 + $85 – $7.05) / 2 = $93.98
Your average price now becomes $93.98!
That is $16.02 lower than your initial price of $110!
Do you now see how powerful the Put Ratio Spread is as a stock repair strategy?
Stock Repair Strategy #3: LEAPS
Last but not least, the final stock repair strategy is using LEAPS Options.
More specifically, buying LEAPS Call Options instead of buying shares.
LEAPS Options are basically Options that have an expiration date that’s a year or longer.
The reason why we want to buy LEAPS Options instead of buying shares is that with LEAPS Options, we can reduce our risk by half or more.
The image above shows the Option chain for the LEAPS Call Options.
If you look at the top of the image, you will see that the Ask of XBI is $80.67.
That means if you were to buy 100 shares of XBI right now, you’d have to pay $8,067.
But if you take a look at the 35 strike price and see the Mark column (which is the mid-price of the Bid and Ask spread), you can purchase this LEAPS Call Option for merely $48.57.
That means it would only cost you $4,857.
That is significantly lesser than buying 100 shares of XBI!
And if you take a look at the 80 strike price, you’d only have to pay $1,795.
And if you really wanted, you could buy the 100 strike price at only $1,062.
That’s one-eighth the price of buying 100 shares!
But here’s the thing…
Even though you can buy these really cheap LEAPS Options, we don’t want to do it.
That’s because of Extrinsic Value.
Extrinsic Value is essentially paying for time on the Option.
The more time there is left until expiration, the higher the Extrinsic Value.
The lesser time there is left until expiration, the lower the Extrinsic Value.
That means that Extrinsic Value ultimately decays to zero when the Option expires.
So we do not want to buy the Options with a high Extrinsic Value because if XBI doesn’t go above our strike price at expiration, we will lose all the Extrinsic Value we paid for.
Instead, we want to only buy the Deep-In-The-Money (DITM) LEAPS Options.
That’s because it comprises mostly Intrinsic Value and very little Extrinsic Value.
Intrinsic Value is simply the difference between the stock price and the LEAPS Option’s strike price.
And unlike Extrinsic Value, it doesn’t decay to zero because of time.
An Option’s Intrinsic Value will remain even at expiration, if there is any Intrinsic Value left.
For example, if the strike price is 50 and the stock closes at $80 at expiration, there’s still $30 of Intrinsic Value left in the Option.
That means it will be automatically exercised by your broker and you will be assigned 100 shares at $50.
Alternatively, you can just sell the Option away to receive the $30 before it expires.
So how do we use LEAPS Options as a stock repair strategy?
Step 1: Identify the level that you plan to Buy the LEAPS Options.
In the above image, I use the example of $85.
Step 2: Look for the longest DTE Option and determine how much you want to risk.
We generally want to look for the LEAPS Options that have DTE 365 and above.
So for example, if you want to only risk $4,000, then you would be looking for the 45 strike price and place a Buy Limit Order for $40.00.
If you want to only risk $3,500, then you would be looking at the 50 strike price and placing a Buy Limit Order for $35.00.
Generally, I want to pay at least 40% – 50% of the level I want to purchase at.
This will ensure that the LEAPS Options have little Extrinsic Value and comprises of mostly Intrinsic Value.
Step 3: Place the Buy Limit Order and wait to get filled.
All that’s left is to place the order and just wait until the market comes to you!
It’s as simple as that.
Now that you know the 3 stock repair strategies, it’s time to start choosing the one you feel the most comfortable with and start implementing it!
Leave a Reply