Using Options to Repair a Portfolio

This quarter's inevitable list of earnings disappointments has combined with the "Spitzer" stocks to create an unusually long list of shares that suddenly have large losses.

Among the names that have been kneecapped over the past few weeks are insurance companies under direct investigation, such as AIG(AIG Quote) and Marsh & McLennan(MMC Quote), and those suffering from collateral damage in the fear they may be next, such as Cigna(CI Quote) and Aetna(AET Quote).

This brought to mind a recent email from a reader who owns UTStarcom(UTSI Quote) from $33 (it's currently trading around $17.50). This reader asked if "there is an appropriate options strategy for recouping losses, because even though I think it will eventually come back over the next year, I would like to recoup some losses without waiting for a 100% stock increase. Should I buy cheaper out-of-the-money calls, or short puts?"

With so many investors facing a similar situation of steep losses, but who still believe that the company in question is a viable and decent long-term investment, I thought it might be useful to look at an options strategy for recouping losses in a shorter time period that requires a small move in price and does not substantially increase risk.

If you buy cheap out-of-the-money calls, you are basically hoping UTStarcom rallies very sharply in a short amount of time, something you say you don't expect to happen. If you sell puts, you are increasing your risk on a one-to-one basis of the existing position while only getting limited profit potential.

One popular strategy for recouping losses in a stock that has suffered a sharp decline is to add a one-by-two ratio call spread to the existing holding. The goal is to increase your long exposure for little or no additional risk or cost. For example, assume you owned 1,000 shares of XYZ, which was currently trading at $20 per share. You would buy up to 10 of the $20 calls and sell up to 20 of the $25 calls for even money.

The position now controls 2,000 shares, double the existing long stock position between the price of $20 and $25 for no additional risk. (Note: Because the long stock and long calls are all covered, there is an equal number of $25 calls sold short, and the maximum profit is achieved and capped at $25 and above. Of course, establishing the spread for even money can be a challenge, but high implied volatility helps and may require using longer-dated options.)