Unless you’re Ray Dalio, chances are your portfolio looks completely broken right now.
With the stock market down 23% this year, nearly all individual investors are showing a loss. That’s true whether you’re an amateur or have years of experience. Whether you’re an option trader or a value investor. Whether you bought Berkshire Hathaway or the Ark Innovation ETF.
My retirement account, for example, is down 11% this year. Not as bad as others, but certainly still a loss.
Losses are normal, even in the best of times. But this isn’t the best of times. And it may be quite a lot longer until the market bottoms out and starts to form a comeback.
Waiting for that comeback is excruciating, yet that’s what most investors will do. They’ll resign to sit through the pain and wait for the new bull market.
But because you’re an option trader, you want to do something to make it happen quicker. Conventional wisdom says that’s not possible. But conventional wisdom is wrong.
Amber noted yesterday that options offer options. She covered straddles and spreads, which are both excellent techniques to use right now. But one lesser-known options technique can actually repair your portfolio after it’s suffered losses.
Today, I’ll share how I learned this technique from a chance encounter with an oil trader years ago, and how you can start using it today to repair the damage 2022 has done to your portfolio…
A Costly Error and a Simple Fix
Years ago, I met a friend of mine for lunch. She was an accomplished market maker for the oil markets.
She got a call from the new trader she hired a couple of weeks earlier. He had made a big mistake.
She said, “you know what to do. How many did you buy?” She calmly told him to buy 75 contracts of one option and sell 150 of a different one. Then, she got back to lunch.
I asked what that was all about. She said the trader made a costly error, but it was fixable. And she was able to use options to fix it.
I’ll be honest, when she told me about this strategy at first, it went over my head. But I got to work practicing it in my own account, and now I utilize it whenever I find myself in a similar situation.
What follows will be a bit challenging, even compared to what you’re used to reading in True Options Masters. But I assure you, it’s worth learning.
When you’re down significantly on a stock position, you can buy at-the-money calls and then sell twice as many out-of-the-money calls. This is called a ratio spread.
It’s similar to a credit spread, except for the fact that you’re selling to open twice as many option contracts as you’re buying.
Here’s an example. I’ll use Carnival Cruise Corporation (CCL) because it fell about 20% in the past few days.
(Note: This is not a recommendation.)
Let’s say you own CCL. You bought it because you knew earnings were coming on September 30, and you were certain they’d be good. So you bought 1,000 shares the day before the announcement for $9.10 a share. Your cost is $9,100.
Unfortunately, it didn’t work out as expected. CCL fell over 20% after the stock reported poor earnings. The $9,100 you spent is now worth $7,200.
You expect it to come back… eventually. In fact, you’d like to buy even more so your average cost is lower. But you don’t have the extra money lying around.
Most investors would just hang on and wait for a comeback, maybe even selling as soon as they break even. But contrary to popular belief, stocks can and do go to zero. So instead of doing that, you decide you want some of your money back now.
To do that, you use the oil market maker’s portfolio repair strategy – a ratio spread.
With the stock at about $6.75 as I write, you could buy 10 of the January 20, 2023, $7.50 calls. The calls are about $1.00 each, so this costs $1,000.
Then you sell 20 of the January 20, 2023, $9 calls. These are trading at about $0.60. That generates $1,200 in income. That more than pays for the calls you bought, so it works out to a credit of $180.
In January, the stock will either be higher, lower, or near the same price. Let’s look at how this trade plays out in each case.
Let’s say the stock goes up to $8. The $7.50 calls you bought are now worth about $0.50. You sell them for $500. (Remember, because you sold 20 of the $9 calls, you didn’t pay anything for this option. So even though they lost value, they add $500 in value to your account.)
Since CCL didn’t rise above $9, the $9 calls you sold expire worthless. Now, with the $500 added to the $130 in income you got up front, you clawed back $630.
Your 1,000 shares are worth $8,000. That means, combined with the ratio spread, your total position is worth $9,680. That’s a $580 profit from where you started, even with the stock still more than 12% below your purchase price.
This is the ideal, and most likely, scenario. But, so you’re aware of the risks, let’s look at another possibility where the ratio spread wouldn’t work…
It’s also possible the stock could gain 100% and trade at $13.50 at expiration. In this scenario, your 1,000 shares are worth $13,500. The $7.50 calls you bought are worth $6,500.
You also sold 20 $9 contracts that you’re now underwater on, and need to buy back. They are worth $4.50 so you must spend $450 per contract to buy them back.
The options net out to a loss of $2,500. Factor in the original $180 credit, and it’s a loss of $2,320. So, while you made money holding the shares, you lost a bit of money on the spread.
In this scenario, where the stock makes an incredible recovery in a short amount of time, you’d be better off without the spread. But stocks that drop 20% in a week rarely go on to double in a short amount of time.
Ratio spreads also help when the stock keeps falling.
Let’s say CCL keeps falling to $5. All of the options expire worthless. You own 1,000 shares worth $5,000. Your $180 premium earned for selling the calls lowered the per-share cost basis by $0.18 and you are 2% closer to breakeven.
If CCL is unchanged, the options also expire worthless. Here, too, you are $0.18 (2%) closer to breakeven.
In summary: This strategy benefits from a mild recovery in the stock. If the stock falls, or does nothing, it cushions the downside and lowers your cost basis. For stocks in a downtrend, these are the most likely scenarios.
If the stock rallies sharply in a short span of time, you could get into trouble. But again, the likelihood of that for a stock in a downtrend is low.
For long-term holdings, it could be useful to keep this strategy in mind. Especially in a bear market, you can use it to recoup some of your losses and make it easier to reach breakeven when stocks turn around.
Ratio Spreads Are the Tip of the Iceberg
There are so many different ways to trade options that most don’t know. I teach all these different strategies at the New York Institute of Finance.
My classes cost almost two thousand dollars — and that’s not for a semester… it’s for just two days.
I’ve always thought that more people should be able to access these courses. So, we just re-created it in a digital format.
It only costs $47, and it details every options strategy under the planet (in less than three hours). It comes with a year’s subscription to my conservative trading strategy Market Leaders — which, by the way, I just added a portfolio of value-rich dividend-paying stocks to.
Oh… and it’s risk-free.
Today is the first time you can access it. You can learn all about it here.
Michael Carr, CMT, CFTe
Editor, True Options Masters