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Let's be honest: We've all broken something, whether it's a favorite coffee mug, a bicycle, a window, a computer, a car, a toy – anything.
Me? I'm usually inclined to try to fix whatever it is before I throw in the towel and replace it.
What a lot of folks don't realize is that trading stocks is the same way.
Now, sometimes there's no fixing it, and you've got to close out a position with a loss. It helps me to think of it as paying for a lesson.
But more often, you can quickly fix that trade and walk off with profit in your pocket – and, of course, the satisfaction of a job well done.
Be Your Own Trade Repair Tech
As we all know, sometimes a fix costs money… Sometimes it costs lots of money.
But the good news is it doesn't have to be like that with your trades. You don't have to double down or pour good money after bad.
In fact, with the technique I'm about to show you, all you really need is the belief – hopefully backed up with evidence – that the stock will rebound.
If you don't believe it will rebound, the smart thing to do is head for the exit.
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Fixing a "broken" stock trade that's moving against you is all about changing one thing: the all-important breakeven. I always say your breakeven is one of the most critically important parts of a trade. The best traders are always conscious of where it is.
There's a few ways you could do that…
Some folks go the HOPE route, as in, they hope and pray the picture changes and they'll at least make it out with a smaller loss.
Some traders might try what I call "buying down the breakeven," which means they're adding more capital to a losing position to bring the breakeven to where they need it to be. They're essentially averaging in, which can be a smart move on long-term, buy-and-hold stocks, but a bad idea for trading. Like I said, it's pouring good money after bad.
But my favorite fix is similar to doubling down, but it doesn't require you to risk any more of your hard-earned money.
Let's say you've bought $100 shares of XYZ at $70 a share. You've got $7,000 at stake. In that case, you're breakeven is $70. You've got unlimited profit potential above $70 and $70 of risk, all the way down to zero.
But say the stock starts to sink, toward $50.
You can buy on the way down, buy another 100 shares at $50 each.
Now you've got $12,000 in this position, and your breakeven is $60, but if the stock starts to sink again, you're losing more. If it hits $50, you're out $2,000. If it goes to $30, you're out $6,000.
Here's what you should do instead.
When the stock drops enough to give you that "uh-oh" feeling, simply…
- Buy one at-the-money (ATM) call option, and…
- Sell two out-of-the-money (OTM) calls for every 100 shares of stock you own.
So when your $70 XYZ shares drop to $50, buy an XYZ call with a $50 strike – and cough up the premium.
At the same time, sell two XYZ $70 calls – and collect the premium.
Your cost here should be anywhere from negligible to zero – depending on how the premiums stack up, you could even make a little money. In any case, it's certainly less than having to pony up an extra seven grand to average in.
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If the premium you get on the two OTM calls covers the premium you pay for buying the one ATM call, your cost is zero.
It's a good idea to date the expiration far enough out that the strike price is equal to your original purchase price.
What you're doing is kind of, but not exactly, like robbing Peter to pay Paul. In this case, the premium you collect for selling the two OTM calls will cover the cost of buying an ATM call. Sometimes you may even net a credit.
Let's look at this on a stock that's been in the news a lot lately…
A Lot of People Are Looking for a Fix for This
I mean Nikola Corp. (NASDAQ: NKLA).
A corporate scandal has sent the stock tumbling from north of $50 to down near $20, and it's creeping back.
To get the strikes we want to save this position, we have to go all the way out to April 2021. The NKLA April 16, 2021 $45 calls strikes are right around where NKLA was trading not long ago – you can sell two of those calls for $4.80 a piece right now.
At the same time, you can now buy, closer to the current stock price, a NKLA April 16, 2021 $25 call for $9.45.
So now, you'd still be down a little over $2,000 on a Nikola position you bought last month, but so long as the stock gets back to $35 by April 2021, you'll have saved your position and perhaps even made a little profit.
And as always, I'll take little or no profits before a total loss any day of the week.
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About the Author
Tom Gentile, options trading specialist for Money Map Press, is widely known as America's No. 1 Pattern Trader thanks to his nearly 30 years of experience spotting lucrative patterns in options trading. Tom has taught over 300,000 traders his option trading secrets in a variety of settings, including seminars and workshops. He's also a bestselling author of eight books and training courses.