Recovering From a Stock Loss Page 1

At one time or another we have all probably been in this position. We bought a stock in anticipation of big gains, and all of a sudden the stock starts going against us. What’s the first thing that pops into our heads? "If I just wait, the stock will come back." So we sit on the stock and we let it drop, and we let it drop, and all of a sudden we realize that we have broken all of our rules. We have completely ignored everything we have learned, and we now have a 20-point loser on our hands. What do we do next? We can't possibly sell the stock or our spouse would probably kill us if they found out. At this point what does everyone say to themselves? "I hate this stock and if it ever gets back to where I bought it I will sell it and never touch it again." After the big drop that we had in the market earlier in the year many of you may have found yourself in this position. Well we may possibly have a solution for you.

We have truly gotten ourselves into a bind. Firstly we have a stock that has to climb 20 whole points to bring us back to a break-even state, and secondly, while we are waiting for this to happen, we have a substantial portion of our portfolio tied up unable to be used for other trades. What if we told you there was a way to use stock options to cut that 20-point climb in half? What if you now only had to wait for the stock to climb 10 points before you could exit the position and break even? Well, we have good news. There is a way and stock options can help you get there.

First let's set the ground rules for this strategy.

Rules:

1. The stock has hit bottom and you expect it to make at least a small bounce from here (this strategy will not work if the stock continues to fall).
2. You simply want to get out of the stock at the point you purchased it. You have no interest in making a profit and intend to sell it immediately when it reaches the point where you purchased it.
3. You are unwilling to assume addition risk or invest additional capital by purchasing additional stock and cost-averaging your position.
4. You realize that by implementing this strategy you will not only be reducing the move that the stock has to make on the upside to return your capital but will also be giving away any potential gains above this level.

In this example, let's say you had purchased 100 shares of XYZ company at $130, and the stock has declined in value and is now trading at $110. The stock has hit bottom and now seems to be making a bounce, but you're not quite sure if the bounce will have enough strength to propel it back to $130. To make things easier, we will detail this process step by step.

Step One: You purchased 100 shares of XYZ on March 2nd for $130 per share.

Step Two: You have sat in the stock, and it is now April 10^th and the stock is down 20 points and trading at $110 per share.

Step Three: You would want to first check to see whether the stock is optionable or not. If it is, you would want to purchase one May 110 Call option. For the purpose of this example, let’s say it costs you 7 ½ or $750.

Step Four: At this point you have the right to control 200 shares of XYZ company at $110 (the 200 share number comes from the 100 shares you own combined with the 100shares that the Call option now entitles you to). You would now want to immediately sell 2 of the May 120 Call options. For the purpose of this example let's say they were able to sell them for $362.50 each, or $725.

Step Five: You have now spent $25 plus commissions to enter this position but you have reduced the move that your stock has to make upward by 10 full points or $1000. Lets now take a look at the scenarios below that outline the changes in our current positions for each potential move in the stock.

Options involve risk and are not suitable for everyone. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options. Copies of this document may be obtained from your broker.