When Stocks Become Sinkholes

As earnings season kicks off, we all know disappointments lie ahead, to be followed by painful selloffs.

Blowups always generate the same inevitable questions. And AutoZone(AZO Quote), Electronic Arts(ERTS Quote) and General Motors(GM Quote) have inspired a flurry of reader emails seeking guidance on either how to minimize the damage or how to seize opportunity.

To Resuscitate, Not Resurrect

As a devoted options columnist, I am obviously a firm believer in the benefits of embracing options in your daily trading life. That said, I also recognize their limitations and always warn they do not offer miracle cures or immediate financial salvation.

So anyone who has seen a position obliterated must first understand that options can do only so much to redeem a position gone bad. Options can give a second wind to positions that still have a pulse, but do not expect them to perform a resurrection. In fact, in the case of a blowup, many professional traders would opt to take the loss and move along to a new opportunity.

The thinking is there are better places to deploy time and capital than fighting what will likely be a losing battle. In fact, when applied to a losing situation, options have the power to make you even more wrong and cause even more pain than if you had just let the position die.

That said, there are some standard operating procedures for at least trying to briefly stabilize before making an honorable retreat. One of the most popular techniques is often referred to as a current portfolio repair (CPR) strategy, which consists of adding a 1-by-2 ratio call spread to the existing holding. The goal is to increase your long exposure at little or no additional risk or cost.

For example, assume you own 1,000 shares of XYZ, which is currently trading at $30 per share. (The cost basis is inconsequential.) You would buy up to 10 of the $30 calls and sell up to 20 of the $35 calls for even money.