How to Repair a Broken Stock

Despite the recent market rally, fully 86% of the stocks that make up the S&P 500 remain at least 20% off their 52-week highs. Sadly, big gainers like Palm (Nasdaq: PALM) and Green Mountain Coffee (Nasdaq: GMCR) were rare occurrences over the past year. So unless you put fresh cash to work in the past two months -- and if you did, nice work -- the odds are you have a number of stocks in your portfolio in desperate need of repair.

Wait. You can repair stocks?
Not all stocks are ideal candidates for the repair strategy I'm about to discuss -- namely, strong companies that generate plenty of free cash flow and are worth holding for the long run. For instance, I wouldn't sell stocks like Costco (Nasdaq: COST), Wal-Mart (NYSE: WMT), or IBM (NYSE: IBM) just because your shares might be 20%-30% below what you originally paid for them. In those cases, you're better off averaging into those positions with more cash to lower your cost basis. Alternately, consider writing puts at strike prices near the going market price.

Similarly, the strategy won't work on stocks you bought that fell too sharply, like Eastman Kodak (NYSE: EK) or AIG (NYSE: AIG) have this year. If you're not prepared to add more cash to these investments, it's probably best to sell and take the loss (and gain a potential tax write-off).

No, the best stocks for the repair strategy are the true laggards in your portfolio. They're probably down 15%-25%, and you have no interest in holding onto them for the long run. Ideally, with these positions, you just want to break even and free up your cash to put into a better investment. Fortunately, the stock repair strategy lets you do just that.

OK, get to the dang strategy already!
For every 100 shares of a losing stock you own:

Buy one call option at a strike price below the current share price.

Sell (write) two call options at a strike price above the current share price.

Use the same expiration date for the options you buy and sell.

Typically, use options that expire in 90 days or less.

Did you get all that? It's a lot to process, I know, so let's walk through an example. Say you bought 100 shares of Company XYZ at $40 a share, but the company hasn't performed as well as you expected. With XYZ now trading at $30 per share, you're down 25% on your investment, and you just want to break even on the trade and move your cash elsewhere.

To repair the XYZ position, you could buy one July 30 call for $2.50 (a debit of $250), and simultaneously sell two July 35 calls for $1.25 each (a credit of $250), and your options positions would pay for themselves.

Great. What happens now?

If your $30 stock...	Then...
Falls to $25 at expiration	It's a wash. All options expire, and you've only lost on commissions. You can try again. Unfortunately, the underlying stock's value has fallen even further.
Gains a little -- say, to $32.50	You make $2.50 per share on your $30 call option, and you've lowered your original cost basis by $2.50, to $37.50. You can use the strategy again.
Recovers to $35	Huzzah! You make $5 per share on your call option, reducing your cost-basis to $35, and your stock is called away at $35. Congratulations, you've broken even.
Soars to $50	You miss out on the stock's unexpected upside, but your trades still cancel each other out, and you still break even.

It's important to note that the repair strategy isn't risk-free. As you can see, it does not protect you from additional downside in the shares you already own -- nor does it offer you a profit above your break-even price. If you think your unwanted stock runs the risk of a sharp near-term decline, just sell it.

What the stock repair strategy offers -- a chance to breakeven on a lagging stock in your portfolio -- is worth considering before you take the loss.

We're teaching all types of options-related strategies like this at our Motley Fool Pro real-money investment service. We're also building a long-term stock portfolio, and using other option strategies both to generate income and create better buy and sell prices on our stocks. If you would like to learn more, simply enter your email below.