Daily graph of L ($67.11 on Tuesday, September 26, 2017)
As you can see in the above graph, the price of Loblaws Companies Limited (L) shares fell 18% from a peak of $78.85 on May 8, 2017, and then bottomed out at $64.65 on September 8, 2017. Since then, we have witnessed a tentative rebound that could suggest the worst is over. Of course, no one can say for sure. But in such case, investors who still hold the stocks could take advantage of the opportunity to implement a repair strategy that may allow them to recover some or all of the losses incurred, without the share price having to return to its May 8 high.
The Repair Strategy
The repair strategy involves purchasing one call option on the stock held while selling two call options on the same stock at higher strike prices than the call purchased. The purpose is to recover fully or in part the losses incurred without significantly increasing the existing risk. It is essentially equivalent to writing a covered call on the existing position while establishing a bull spread. This strategy allows us to double our potential gain in the event of an upswing without adding any significant downside risk.
Suppose an investor was unlucky enough to purchase 1,000 L shares at $78.85 on May 8, 2017 and still holds the position as L stocks are trading at $67.11 at market close on September 26. The investor’s losses amount to $11,740 [($78.85 – $67.11) x 1,000 shares].
To implement a repair strategy, the investor could carry out the following trades:
- • Buy 10 call options, L 20180119 C 64, at $4.45 per share
- • Sell 20 call options, L 20180119 C 72, at $0.70 per share
- Total debit of $3,050
Profit and loss diagram
As you can see in the above graph, the strategy implemented does not permit to recover the total losses incurred. However, a rise in the stock price to $72 would bring the loss down to $1,900. Without the use of options, L would have to rally back to $76.95 ($78.85-$1.90) to achieve the same result. Furthermore, the risk of loss is only increased by the additional $3,050 debit. The disadvantage of this strategy is that potential gains are limited if the share price rises above the strike price of the call options sold. This should be taken into account before implementing a repair strategy.
Follow-up on the Position
Once the stock hits the strike price of $72, investors still have the option to re-evaluate whether it is worth retaining their stock. If so, they might consider rolling over their position by liquidating their existing options and establishing new ones at new strike prices.
Good luck with your trading, and have a good week!
The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.
Monetis Financial Corporation
Martin Noël earned an MBA in Financial Services from UQÀM in 2003. That same year, he was awarded the Fellow of the Institute of Canadian Bankers and a Silver Medal for his remarkable efforts in the Professional Banking Program. Martin began his career in the derivatives field in 1983 as an options market maker for options, on the floor at the Montréal Exchange and for various brokerage firms. He later worked as an options specialist and then went on to become an independent trader. In 1996, Mr. Noël joined the Montréal Exchange as the options market manager, a role that saw him contributing to the development of the Canadian options market. In 2001, he helped found the Montréal Exchange’s Derivatives Institute, where he acted as an educational advisor. Since 2005, Martin has been an instructor at UQÀM, teaching a graduate course on derivatives. Since May 2009, he has dedicated himself full-time to his position as the president of CORPORATION FINANCIÈRE MONÉTIS, a professional trading and financial communications firm. Martin regularly assists with issues related to options at the Montréal Exchange.