Call Ratio Spread Strategy.

This strategy can be used in a situation when a stock position that one holds has gone down in value considerably and one would like to get out of the position gracefully with minimal downside (potentially a profit!). This strategy is contrary to selling the stock at a loss or holding onto it in the hope it will rise back to the initial entry position. 

Premise: Stock is going to increase sometime into the future

Initial Entry into position and situation:

Trader Joe bought 100 shares of stock A at $160 in January 2013.
Stock A falls to $137 in a month.
Trader Joe does not want to sell the position.

Call ratio spread:

• Buy one May 135 call for $14
• Sell two May 150 calls for $7.50 a piece
• A net credit of $1 (7.50 * 2 - 14) is collected

Scenarios:

Following scenarios are possible.

Decline: 

Stock A continues to decline below $137, all calls expire worthless and Trader Joe keeps net credit less commissions). Downside is stock loses more value.

Flat: 

Stock A stays between the value of the two calls ($135 and $150). The short calls expire worthless, while the long call will become in-the-money and potentially can generate a profit.

Rises:

Stock A moves above $150. The two short calls will likely be exercised but both are covered (one by the long stock position and the other by the long call position).

For any potential upside, Trader Joe will not be able to get any benefit.

Assumptions:

Trader Joe is confident and expects from his research that this stock will move up as the current decline is due to margin calls that may have been raised because of a short term decline in the stock.

Conclusion:

Hold the stock:

Trader Joe holds onto the stock until it reaches $160 to break even. (up by 16.8%)

Sell the stock now:

Cut the loss at $23 a share ($2300 loss)

Stock Repair:

Upside breakeven lowered to $147. (up 8.8%)
Note: Max profit potential limited to $600. Loss to the downside lessened by $100 credit received.

Double up to catch up:

Double the risk of a losing position (Cut losses, let profits run!)

Management Responsibility:

Advanced strategy requires monitoring of the positions

What is your exposure?

Delta=exposure to price moves

• Lower initially

Gamma=change in exposure to price moves

• Negative

Theta=time decay

• Positive

Vega=exposure to change in implied volatility

• Negative

Expiration Responsibilities!

All calls OTM (Stock A is below $135) -> No action required

Both legs expire worthless, Trader Joe keeps a small compensation in the form of $100 credit

All calls ITM (Stock A above $150) -> Legs will auto exercise

Long shares cover one short 150 call, long 135 call covers the second short 150 call

Long call ITM (Stock A between 135 and 150) -> Exercise/sell long call for a profit