Spreads are strategies that do not involve the use of any security other than another option. Their positives are that they are inexpensive, offer protection for both buyer and seller and are in effect automatically hedged trades.

Spreads can provide large percentage returns with low risk and can be entered into with small capital outlay. A spread involves the purchase of one option in conjunction with the sale of another option. There are many types of spreads. Some take advantage of stock movements while others are set up to take advantage of movements in implied volatility and even time decay. There are calendar or time spreads, diagonal spreads, ratio spreads and also vertical spreads, which we will discuss in depth here.

Spreads are more advanced and sophisticated than the strategies discussed in our beginner product “OPTIONS 101.” Where certain spreads, like 1 to 1 vertical spreads, can be less risky than a buy-write, there are more variables to consider and control which makes trading the spread more complicated.

When you trade a spread you are dealing with three elements: the spread as a whole (which you can buy or sell) and its component parts – the option you buy and the option you sell.

Next, you must figure out how to adjust your present position and change it into an advantageous position for a profitable outcome. That might mean selling out of the position totally. Your changes to the position must not only be correct, but also done in the most efficient, cost-effective manner including keeping commission prices down.

It is also important to note that you should make sure to go from a hedged position to another hedged position to ensure proper risk management.

The time spread is an excellent strategy for premium sellers who want to capture premium in a hedged way. It is best used in stagnant periods when a stock is likely to remain in a tight price range. It is less expensive and less risky than most other premium collecting strategies thus is friendlier to investors who are short on capital and experience. It can also be used to take advantage of volatility changes and even some directional stock movements.

The time spread can leave you with a residual naked position that needs to be managed for risk at expiration of the front month option. As always, it is important to fully understand the risks and rewards of the strategy and the potential risks and solutions of the residual position before executing the strategy.

Time spreads are unlike all the other strategies we have discussed before when we talk about rolling or continuing the position. In other strategies, the option component is limited to a single month. At expiration, the position disappears. It either transforms into stock or expires worthless leaving you with no option position. It is different in the case of a time spread because you are dealing with two different expiration months. After the front month expires, in addition to a potential stock position, you will still have an option position – the out-month option will still have time until expiration. To properly roll that position, you must first understand the new position you have inherited.

Let’s look at the call time spread first. For the purposes of our example, let us pretend we are long the September / October 25 call spread. If the stock were to close below $25.00 on expiration Friday of September, the September 25 calls would expire worthless and you would be left with a long October 25 call position. From this position, you would have several things that you could do.

First, you could just sell out the October 25 call. Hopefully, the combination of the expiration of the September 25 calls and their subsequent worthlessness along with the proceeds gained from the sale of the October 25 calls after September expiration might make a profitable trade.

You could keep the position open and continuing in several ways. You could stay long the October 25 call naked. You could sell the October 30 call and become long the October 25 / 30 vertical call spread if you are bullish. You could sell the October 20 call and become short the October 20 / 25 vertical call spread if bearish.

You could buy the October 25 puts and become long the October 25 straddle if you felt the stock would become volatile. You could even sell the stock and create a synthetic put if you were very bearish. There are ways to create a new position that reflects any possible future outlook an investor can have.

If the stock were to close above $25.00, then the September 25 call would close in-the-money. At that time, you would be assigned your short September 25 call and that would translate into a short stock position. That short stock position that you received from the assignment of your short September 25 call along with the remaining October 25 long call position is the equivalent of a synthetic put. At this time, you could close out the position or keep it.

The position is a bearish one so if you felt the stock would be heading down, you could keep the position on. You could sell another option of a different strike to set up either a bull or bear put spread. You could buy the October 25 call to create a long straddle. As you see, there are many different combinations that could be created.

If you were short the September / October 25 call time spread and the stock expired under $25.00 on expiration Friday of September , then you would have a remaining position of a short October 25 call naked. Again, there are many potential ways of continuing the position. Of course, you could always buy back the naked call and close the position if you no longer wanted to maintain a position in the stock.

If you did, you could buy a call in the same month and create a vertical spread, sell the corresponding put and create a short straddle, buy the stock one to 1 and create a buy-write or other combination based upon what you felt the stock would do.

If the stock closed above $25.00 and you were short the call time spread, then you would be left with a long stock position from your long September 25 call and short the October 25 call against the long stock position. The position you would be left with is a buy-write. Depending on your outlook for the stock, you could keep the buy-write on, take it off, or use other options to change the position to what you want it to be.

As far as put spreads, let’s take an example and see where we are when the front month option expires. We will use the September / October 25 put spread for our example.

When long the spread, and the stock closes above $25.00, the September 25 puts, which you are short, will expire worthless leaving you with a long naked put position. From that position, you can close it or combine it with other option or stock to create a different position. Again, there are many different possibilities.

If you were short the put time spread, and the stock closed above $25.00 then the September 25 put, which you are long, will expire worthless leaving you with a short naked put position in the October 25 puts. This position can be closed out or combined with other options or stock to create a strategy that will take advantage of the outlook you have on the stock.

When the stock closes below $25.00, the scenario is different. When long the spread with the stock closing lower than the strike price, the front month put which you are short will be assigned to you thus making you long stock in addition to your long October 25 put. This position is known as a synthetic call.

As before, there are many ways to combine other options and/or stock to change the position so that it is in line with want it to be going forward.

First is a decrease in implied volatility. As volatility decreases, the out-month option (which the seller is short) loses money faster than the near month option (which the seller is long) because of the higher vega in the out month option. This will cause the spread to contract or lose value. That will be profitable for the time spread seller.

Second, the stock can move. As stated before, a time spread is at its widest, most expensive point when it is at-the-money. A movement away from the strike in either direction decreases the value of the spread. So, as long as the stock moves in either direction away from the strike, the seller’s position could be profitable provided that time decay does not outperform the stock movement.

Time, unfortunately, never works in favor of the time-spread seller. The passage of time hurts the seller because the nearer month option (which the seller is long) naturally decays at a faster rate than does the out-month option (which the seller is short). These differing decay rates cause the spread to expand and increase in value. That obviously produces a loss for the time spread seller. Time can neither be stopped nor turned back. It only moves forward which always hurts the time spread seller.

Increases in implied volatility are also detrimental to the potential profits of the time- spread seller. When implied volatility increases, the out month option (which the seller is short) increases in value faster than the near month option (which the seller is long) due to the out month option’s higher vega. This creates an expansion in the spread and increases its value resulting in a negative for the spread seller.

The seller, in theory, has an unlimited loss potential. For the seller, the maximum loss potential is not so much determined by the stock price movement but by the movement in implied volatility. As the seller, you will be long the front month call and short the out- month call. As we know, the out month call will be more sensitive to movements in implied volatility due to a higher vega or volatility sensitivity component. If implied volatility increases then the seller’s short, out month option will increase more in value than will the seller’s long, front month option. This will cause the spread to widen or increase in value; that is negative for the seller.

The second risk is that the option the seller is long is going to expire approximately 30 days prior to the option the seller is short. If volatility does not decrease or the stock does not move away from the strike significantly before the seller’s long option expires, he/she will be left short a naked or un-hedged option and a loss on the position. If the seller can wait out the position, the lost extrinsic value of the short option can be recaptured. As we know, this option too has a limited life and must shed its extrinsic value, no matter how much, by its expiration. The problem facing the seller is that the position is no longer hedged and the seller now faces unlimited risk.

The buyer can profit in several ways. First and foremost, being a time spread, the buyer can profit by the passage of time. Options are wasting assets. So as the nearer month option decays away more quickly than the outer-month option, the spread widens (increases in value) and the buyer sees a profit.

Second, implied volatility can increase. As implied volatility increases, the out-month option, which the buyer is long, increases in value more quickly (due to its higher vega) than the nearer month option which the buyer is short. This will force the spread to widen or increase in value, which again is profitable for the buyer.

Third, the buyer can make money due to stock price movement. As stated before, a time spread’s value is at its maximum when the stock price and the spreads strike price are identical (at-the-money). You could have an increase in value if you owned an out-of-the-money or in-the-money time spread, and the stock moved either up or down toward your strike. As the stock moves closer to your strike, the spread will expand and increase in value creating a profit for you, the buyer.

The buyer’s risks are obviously the opposite of the rewards. You can not stop or reverse time so the buyer of the spread can never be hurt by time.

Implied volatility, however, can decrease as easily as it can increase. A decrease in implied volatility will decrease the value of the out-month option (which the buyer is long) faster than it will decrease the value of the nearer month option (which the buyer is short) due to the higher vega of the out-month option. This will narrow the spread thereby creating a loss for the buyer.

Looking at this first adjustment where we moved the June 70’s volatility down to 36 from 40, we have a value of $1.80 at 36 volatility. The August 40 call has a value of $3.00 at 36 volatility. So the spread will be worth $1.20 at 36 volatility.

If you wanted to move the August 70 calls instead, you would take the August 70 call vega of .08 and multiply it by the four tick implied volatility difference.

This gives you a value of $.32 that must be added to the August 70 call’s present value in order to bring it up to an equal volatility (40) with the June 70 call. Adding the $.32 to the August 70 call will give it a $3.32 value at the new volatility level of 40 which is the same volatility level as the June 40 calls.

Now, our spread is worth $1.32 at 40 volatility. August 70 calls at $3.32 minus the June 70 calls at $2.00 gives the price of the spread at 40 volatility.

It does not make any difference which option you move. The point is to establish the same volatility level for both options. Then you are ready to compare apples to apples and options to options for an accurate spread value and volatility level.

Since we now have an equal base volatility, we can calculate the spread’s vega by taking the difference between the two individual option’s vegas. In the example above, the spread’s vega is .03 (.08 – .05). The vega of the spread is calculated by finding the difference between the vega’s of the two individual options because in the time spread, you will be long one option and short the other option.

As volatility moves one tick, you will gain the vega value of one of the options while simultaneously losing the vega value of the other. Thus the spread’s vega must be equal to the difference between the two options vega’s. So, our spread is worth $1.20 at 36 volatility with a .03 vega or $1.32 at 40 volatility with a .03 vega.

Going back to our original spread value of $1.00 with a vega of .03, we can now calculate the volatility of that spread.

We know the spread is worth $1.20 at 36 volatility with a vega of .03. So, we can assume that the spread trading at $1.00 must be trading at a volatility lower than 36.

To find out how much lower we first take the difference between the two spread values which is $.20 ($1.20 at 36 volatility minus $1.00 at ? volatility). Then we divide the $.20 by the spread’s vega of .03 and we get 6.667 volatility ticks. We then subtract 6.667 volatility ticks from 36 volatility and we get 29.33 volatility for the spread trading at $1.00.

We can also determine the volatility of the spread as the spread’s price changes. Let’s fix the spread price at $1.30. To calculate this, we must first take the value of the spread ($1.20 at 36 volatility) and find the dollar difference between it and the new price of the spread ($1.30). The difference is $.10. This dollar difference must now be divided by the vega of the spread. The $.10 difference divided by the .03 vega gives you a value of 3.33 volatility ticks. Then add the 3.33 ticks to the 36 volatility and you get 39.33 as the volatility for the spread trading at $1.30.

Let’s double-check our work by calculating the volatility the other way.

This time we will do the calculation by moving the August 70 calls up to the equal base volatility of the June 70 calls. As calculated earlier, the August 70 calls will have a value of $3.32 at 40 volatility.

The June 70 calls are worth $2.00 at 40 volatility. Thus the spread is worth $1.32 at 40 volatility.

Now let’s again move the spread price to $1.30, $.02 lower than the value of the spread at 40 volatility. As before, we take the difference in the prices of the spread. The result is $.02 ($1.32 – $1.30). Then, divide $.02 by our spread’s vega of .03 (remember that the vega of the spread is equal to the difference between the vega of the two individual options). $.02 divided by .03 gives us a value of .67. That .67 must be subtracted from our base volatility of 40. That gives us a 39.33 (40 – .67) volatility for the spread trading at $1.30. This volatility matches our previous calculation perfectly.

At first glance, you might be wondering why we went through all of these calculations. With the June 70 calls at 40 volatility, price $2.00, vega .05 and the August 70 calls at 36 volatility, price $3.00, vega .08 why not just take an average of the volatility? This would give us a 38 volatility for the spread with a price of $1.00 when in actuality $1.00 in the spread represents a 29.33 volatility.

This would be almost a nine tick difference which represents a whopping 30% mistake! Because, as stated earlier, vega is not linear; you can not weigh each month evenly and just take an average of the two months. For argument’s sake suppose you did. Let’s say you found the difference of the vegas of the options and came up with a spread vega of .03 which is correct. However, when you try to calculate the spread’s volatility and price you would have difficulty.

Since they are weighted differently, you can not simply take the average of the two months and call that the volatility of the spread; it is more complicated than that.

The problem is related to calculating the spread’s volatility with two options in different months. Those different months are usually trading at different implied volatility assumptions. You can not compare apples with oranges nor can you compare two options with different volatility assumptions.

It is important to know how to calculate the actual and accurate volatility of the spread because the current volatility level of the spread is one of the best ways to determine whether the spread is expensive or cheap in relation to the average volatility of the stock.

There are several ways to calculate the average volatility of a stock. There are also ways to determine the average difference between the volatility levels for each given expiration month. Volatility cones and volatility tilts are very useful tools that aid in determining the mean, mode and standard deviations of a stock’s implied volatility levels and the relationship between them.

The present volatility level of the spread can then be compared to those average values and a determination can then be made as to the worthiness of the spread. If you now determine that the spread is trading at a high volatility, you can sell it. If it is trading at a low volatility, you can buy it. But first you must know the current trading volatility of the spread.

In order to accurately calculate volatility levels for pricing and evaluating a time spread, the key is to get both months on an equal footing. You need to have a base volatility that you can apply to both months. For instance, say you are looking at the June / August 70 call spread.

June’s implied volatility is presently at 40 while August’s implied volatility is at 36. You can not calculate the spread’s volatility using these two months as they are. You must either bring June’s implied volatility down to 36 or bring August’s implied volatility up to 40. You may wonder how you can do this.

Actually, you have the tools right in front of you. Use the June vega to decrease the June option’s value to represent 36 volatility or use August’s vega to increase the August option’s value to represent 40 volatility. Both ways work so it doesn’t matter which way you choose.

As you can see, if an investor bought the time spread at low volatility and within a few weeks volatility had increased and pushed the spread price higher, the investor could sell the spread at a profit even before expiration.

Of course, the vega can also demonstrate the opposing effect. As implied volatility decreases, the spread tightens or decreases in value. As volatility comes down, the out-month option with its higher vega will lose value more quickly than will the nearer month option with its lower vega. In the chart below, you will see how the time spread’s value is affected by decreasing volatility

Glance back to Charts 4 and 5. Take note that the stock price is constant. The changes in the price of the spreads are due to the change in volatility.

Vega can also be used to calculate how much a specific option’s price will change with a movement in implied volatility. You simply count how many volatility ticks implied volatility has moved.

Multiply that number times the vega and either add it (if volatility increased) to the option’s present value or subtract it (if volatility decreased) from the option’s present value to obtain the option’s new value under the new volatility assumption. The calculation works on individual options and can be used to calculate the value of the time spread.

Now, let’s apply the concepts of vega to the Time Spread.

When you apply the vega concept to time spreads, you observe that as implied volatility increases, the value of the time spread increases. This is because the out-month option, with the higher vega will increase more than the closer month option with the lower vega. That widens or increases the spread.

An option’s volatility component is measured by a term called vega. Vega, one of the components of the pricing model, measures how much an option’s price will change with a one point (or tick) change in implied volatility. Based on present data, the pricing model assigns the vega for each option at different strikes, different months and different prices of the stock.

Vega is always given in dollars per one tick volatility change. If an option is worth $1.00 at a 35 implied volatility and it has a .05 vega, then the option will be worth $1.05 if implied volatility were to increase to 36 (up one tick) and $.95 if the implied volatility were to decrease to 34 (down one tick). Remember, vega is given in dollars per one tick volatility change.

As we continue to discuss vega, keep these facts in mind

1. Vega measures how much an option price will change as volatility changes.

2. Vega increases as you look at future months and decreases as you approach expiration.

3. Vega is highest in the at the money options.

4. Vega is a strike-based number – it applies whether the strike is a call or a put.

5. Vega increases as volatility increases and decreases as volatility decreases.

It is important to note that an option’s volatility sensitivity increases with more time to expiration. That is, further out-month options have higher vegas than the vegas of the near term options. The further out you go over time, the higher the vegas become.

Although increasing, they do not progress in a linear manner. When you check the same strike price out over future months you will notice that vega values increase as you move out over future months.

The at-the-money strike in any month will have the highest vega. As you move away from the at-the-money strike, in either direction, the vega values decrease and continue to decrease the further away you get from the at-the-money strike.

Remember, vega (an option’s volatility component value) is highest in at-the-money, out-month options. Vega decreases the closer you get to expiration and the further away you move from the at-the-money strike. The chart below shows vega values for QCOM options.

As you look at the chart observe the important elements: the stock price is constant at 68.5; volatility is constant at 40; time progresses from June to January; and finally, the strike price changes from 50 through 80. Notice the increasing pattern as you go out over time. Also notice how the value decreases as you move away from the at-the-money strike.

In the same way that a time spread loses value as the stock price moves away from the strike price, the opposite is true also. As the stock price moves closer to the strike price, the value of the time spread increases.

For example, let’s examine the June / July 65 call time spread. With the stock priced at 65 (directly at the strike) the spread is at its widest point (highest value). Now, as the stock climbs away from 65 and pushes toward 70, the June / July 65 spread loses value.

However, at the same time the June / July 65 loses value, the June / July 70 spread gains in value as the stock approaches the 70 strike. When the stock reaches 67.50 the point equidistant (mid-point) between the two strikes, both spreads will be trading at approximately the same value.

Look at chart 2. Notice that as the stock increases from 57.50, both the June / July 65 and June / July 70 spreads increase in value. Their increases continue until they reach their strike price at which time they both begin to lose value.

This demonstrates that the spread with the strike price that the stock is moving toward will increase in value while the spread with the strike price that the stock is moving away from will simultaneously lose value.

Chart 2 follows the effect of the movement of the stock price across the two time spreads.

A time spread is designed to take advantage of the fact that an option’s decay curve is non-linear; that is, an option’s value does not decay evenly over time. As an option gets closer to expiration, its rate of decay increases meaning the option loses value more quickly. That decay rate increases progressively day after day until expiration.

An option’s decay rate begins to accelerate when the option is about 45 days out. It picks up steam at 30 days out and really comes under decay pressure at about 15 days out. This scenario can be likened to a boulder rolling down from the top of a hill. As it starts, it rolls slowly and then gains more and more speed and momentum the further it gets down the hill until it achieves its maximum speed at the bottom.

Option decay acts the same way- gathering speed and momentum as the option approaches expiration. In time spreads, both options have the same strike price that remains constant.

However, each option’s value decays at different rates and over different lengths of time. The option with one month until expiration experiences value decay at a faster rate than the value of an option that has three months until expiration.

If you buy an option with three months to go and sell an option with the same strike but with one month to go you have set up a spread between the two options values (prices). As time passes, your short option loses value more quickly than your long option that decays more slowly. The value of the spread widens and you profit from that spread’s expansion. This is the fundamental behavior of the time-spread.

The above chart shows an option decay graph. The numbers across the bottom represent days to expiration. Along the decay line, you will notice an “X” at the 30 day to expiration line and another “X” at the 60 day to expiration line. The first “X” represents a 30 day option while the second “X” represents a 60 day option. If you look closely at this chart you will see the nature of the time spread.

Let’s say you are long the 60-30 day time spread. That means you are long the 60 day option and short the 30 day option. Further, we will assign a price of $3.00 to the 60 day option and $2.00 to the 30 day option. Since you pay for the one and receive payment for the other the bottom line cost of what you put out for the spread is $1.00.

Now, look at the slope of the line (representing decay) drawn from the 60 day option to the 30 day option. Compare the slope of that line to the slope of the line drawn from the 30 day option to expiration (Day 0). As you can see, there is a big difference in the steepness of the slope of the two lines. The slope of the line drawn between the 30 day option to expiration is much steeper than the slope of the line drawn from the 60 day option to the 30 day option.

These slopes show how the time spread works! During the first 30 day period of time, the 30 day option has a steeper slope, meaning a higher rate of decay. During that 30 day period, this option will go from $2.00 to $0. Meanwhile, the 60 day option, having a flatter slope will not decay as quickly.

During the same 30 day period, it goes from $3.00 to $2.00. Remember, the spread’s bottom line cost was $1.00. The 30 day option (now expired) will be worth $0 while the 60 day option (now 30 day option) will be worth $2.00. If you had invested in this spread, after 30 days decay you would be holding one option worth $2.00. The investment has provided a nice return!

However, this is an ideal situation. The stock price and volatility remain constant and you capture the decay. The time spread has worked just as it should and it does work that way sometimes. But, nothing works as it should all the time. As we know, stock prices and volatility levels do not remind constant.

The time spread, like other spreads, has its risks and rewards. The risk is very limited for the buyer, but substantial for the seller. The seller’s risk can be avoided or contained with due diligence at the expiration of the near month’s option. Also, there are a variety of strategies that can affect the seller’s risk.

The advantage of this strategy is that the investor can pursue a time decay or volatility position without the large capital outlay necessary for the purchase of the stock.

Construction of the Time Spread

The construction of the time spread involves the purchase of one option and the sale of another in different months, but with both having the same strike. You can construct a time spread using either two calls or two puts.

A long time spread is constructed by purchasing the out month option and selling the nearer month option. For example, you buy the September 45 call and sell the August 45 call or buy April 30 puts and sell February 30 puts. A short time spread is constructed by selling the farther out month and buying the nearer month. For instance, sell July 50 calls and buy May 50 calls.

The important elements in the construction of the time spread are: use two call or two put options on the same stock, use the same strike for both, choose different months for each and use a one to one ratio. A one to one ratio means that you must purchase one option for every one you sell or sell one option for every one you buy. A time spread can utilize any two months as long as it has the same strike price and the trade is done in a one-to-one ratio.

Most time spreads are executed at-the-money because at-the-money options have the greatest amount of extrinsic value. An option’s extrinsic value is what decays over time and is the basis of the time spread’s strategy. Since the time spread is built to take advantage of time decay it is naturally better suited for at-the-money options.

This does not mean that the time spread can not be used effectively with in-the-money or out-of-the-money options. In-the-money and out-of-the-money options have less extrinsic value than at-the-money options.

As you can see from the chart, the Stock Repair Strategy will get your position back to even at the same place as doubling down would have, and in half of the move required to recover your losses by just holding onto the stock. In our example, the prices are constructed to make the calculations easier and to work out so that the trade incurs no debit or credit. As mentioned previously, it is not often that the numbers work out this evenly.

Ideally, this 1 x 2 spread will be purchased for a credit; that is you will receive a little profit up front by doing the trade. It will not be much, but this credit (profit) should be factored into your return.

If you can’t get the spread for a net credit, it is important to note that the closer to even that the trade sets up for, the better result you will see from the trade. Remember, since the trade will be very close to even to begin with, it is only important to note that the closer the trade is to even, the better – unless you can put it on for a credit.

Conclusion: The goal here is to try to make back the money lost without the stock having to trade all the way back to the original level. Doubling down (also known as “Dollar Cost Averaging”) does accomplish this but you must have substantial additional funds to cover another stock purchase and you must be aware that you now have twice the size of the position thus twice the risk if the stock continues to trade down. This can translate into even larger losses on continued downward movements.

Also note that Stock Repair works best on more volatile stocks trading in wide intraday ranges, because the volatilities will be higher so you can generally sell the out of the money calls for more money.

It also works best on a stock that recently declined rapidly, and lost 10 – 25% of it’s value unexpectedly, because here you would most likely expect to see some degree of technical bounce. Generally, you would also be able to receive higher premiums from selling the out of the money calls while volatilities are high, to offset more of the cost of the at the money calls you would purchase.

Knowing this, the Stock Repair Strategy, alleviates the two major risks of the “Doubling Down Strategy” while still allowing for recapturing losses in less of a move if the stock rebounds.

First, the reason we buy one option and sell two is so that we do not have to put up additional capital, as you would have to when doubling down. You may have to put out a small amount of money if the 1 by 2 spread produces a debit, but it will be pennies on the dollar compared to another stock purchase, plus commission costs.

Second, the Stock Repair Strategy allows an investor to recover from a loss with less of an upward move in stock price.

If the stock continued to trade down, the option position would produce no additional loss. Because it didn’t cost you anything (ideally) to initiate this strategy, you will not lose anything additional on the spread as the stock trades down further.

This is a major advantage over doubling down, because the spread cannot add to the existing losses of the stock position.

With the stock trading down and closing below $30.00, the February 30 calls and the Feb. 35 calls will both expire worthless. Since the cost of construction of the stock repair strategy didn’t cost you anything (in our example), and the trade is now worthless, then you haven’t lost anything additional. Although your stock position will continue to lose, it will not be compounded by doubling your stock position or doubling down.

If the stock stays stagnant and closes at $30.00, again the position will not make or lose anything additional. With the stock at $30.00, both the February 30 calls and the February 35 calls will expire worthless.

The up scenario is where the stock repair strategy is really powerful. The best way to see how this strategy works on the upside is to fix the stock price at different levels. With the stock at $31.00, the Feb 30 calls are in the money and will be worth $1.00 while the Feb. 35 calls that you sold are out-of-the-money and will be worth 0.

This gives the 1 by 2 spread a value of $1.00. You purchased the spread for “even money” so you now have a $1.00 profit on the spread. Meanwhile, since you still own the stock, it is also up $1.00. So, with this $1.00 movement, you have recovered $2.00 of your losses back. This continues to work this way as the stock rises up to $35.00. At $35.00, the Feb. 35 calls will still have no intrinsic value, therefore the 1 x 2 spread which you own is now worth $5.00.

At this moment, with the stock recovering from $30.00 to $35.00 and the spread earning $5.00, you are now even in your overall position. You had originally lost $10.00 on the stock trading down from $40.00 to $30.00. Now, with the help of the Stock Repair Strategy (1 x 2 spread) you have made your loss back on a 50% retracement bounce from the original loss ($40 -> $30 -> $35) without having to take on any additional risk, as in the case of doubling down.

Now, if you were concerned about being long only 5 options versus being short 10 options, you should be congratulated for your observation of potential risk. Once the stock trades over 35, the Feb. 35 calls become in-the-money and have value. As the stock continues up the Feb 35 calls will start to outpace the Feb 30 calls in value.

However, there is not cause for concern because the 5 ITM calls that you own, coupled with the 500 shares of stock that you originally bought, are now moving up in tandem with your short calls, so any loss you experience with them over $35 will be ‘covered.’

Remember, you still own 500 shares of XYZ. No matter how much higher above $35.00 the stock goes, each of the Feb. 35 calls is covered. Five are covered by the long Feb. 30 calls, which created a 1 x 1 vertical call spread (Feb. 30 – 35 call spread.) and the other Feb. 35 calls are covered by your long stock. You own 500 shares and that matches the 10 short Feb. 35 calls exactly when coupled with your long Feb 30 calls. This is why the exact volume construction we talked about earlier is so important.

The construction of this trade is critical. First, you must make sure to purchase exactly the equivalent amount of at-the-money call options as shares of stock you own. Remember, each option contract is worth 100 shares. So if you own 500 shares, then you would purchase 5 at-the-money calls. If you owned 3000 shares then you would purchase 30 at-the-money calls.

Now that you have purchased the correct and exact amount of at-the-money calls, you then must sell exactly twice the amount of out-of-the-money calls. Again, it is imperative that you sell exactly two times the amount of out-of-the-money calls as the amount of at-the-money calls you own.

Looking at the case in which you owned 500 shares and bought 5 at-the-money calls, you would then have to sell 10 out-of-the-money calls to properly construct the Stock Repair Strategy.
Likewise, in the case where you owned 3000 shares and bought 30 at-the-money calls, you would then have to sell 60 out-of-the-money calls for proper Stock Repair Strategy construction.

Here’s why. The 500 shares of stock you have, along with the 5 call options you just bought, will result in an even spread trade. The reason this is important is because without owning the equivalent of 10 calls (or 1000 shares of the underlying stock), then the 10 out of the money calls you sell would be considered ‘naked’ and may require an additional margin requirement.

Selling naked calls is considered risky. However, by owning 1000 shares of stock (or 10 call options) at a lower price, your risk is limited because your sold calls are considered ‘covered.’

The chart below shows some examples of the correct Stock Repair Strategy ratios.

The total dollar value of the options’ trade should be neutral or very close to neutral. In this way, you can establish the position without putting out any more money or at least very little.

In some cases, you can even put on this trade for a credit, whereby you can sell the out of the money calls for more than you paid for the at the money calls. This scenario is ideal, because then you also profit from this part of the trade – also known as a credit spread. (Remember, you will be selling the out of the money calls in a 2:1 ratio to the at the money calls you purchase.)

The out of the money calls will invariably be cheaper than the calls you buy, but the 2:1 ratio makes up for the difference in pricing. The easiest way to explain this is by example. Again, we will go back to our XYZ example. You have purchased 500 shares of XYZ for $40.00. The stock then trades down to $30.00 leaving you with a $5,000 loss.

At this point, at $30.00, you would construct the Stock Repair Strategy. (Option prices are for example purposes only.) You would buy 5 February 30 calls for $1.50 and sell 10 February 35 calls for $.75 each. This strategy is known as a 1 by 2 spread.

We have all found ourselves in situations where we have purchased stock that proceeded to trade down leaving us with a loss or a losing position that we had to fix.

During the recent bull market, a common solution was to buy more of the stock at its lower price and wait for it to go up. This strategy of buying more is called “doubling down.” This is a risky strategy and not what we recommend, but let’s review it anyway.

Doubling down allows investors to lower their dollar cost per share so that the stock only has to gain back a portion of the loss to reach break even.

For example, let’s say you purchased 500 shares of XYZ stock (XYZ) for $40.00 per share. Your capital layout would be $20,000. (Commission costs, which vary greatly, are not included in our calculations of stock transactions but should be included when you figure your bottom line.)

Now let’s suppose that the stock immediately dropped down to $30.00 per share. You would have a $5,000 loss on your investment. In order for you to recoup your $5,000 loss, the stock would have to trade back to $40.00.

The doubling down strategy would have you buy another 500 shares at $30.00 which would give you a total of 1000 shares. (500 shares purchased at $40.00 and another 500 shares at $30.00). This would produce an average purchase price of $35.00 per share on 1000 shares, and is known as “dollar cost averaging.”

With the stock at $30.00, you are now only $5.00 away from being even instead of $10.00 away. This is because you now own 1000 shares at an average price of $35.00. With this position, the stock would only have to trade back up to $35.00 for you to break even instead of the stock having to trade all the way back to $40.00.

However, if the stock did trade back up to $40.00, you would see a profit of $5.00 per share on 1000 shares, for a $5,000 profit.

This strategy worked very well during the bull market and for years, many investors made large sums of money buying the dips and doubling down.

In the table below, let’s assume that we purchased the stock at $40, as in our example above, and then purchased additional shares at the new stock price.

When the bubble burst, the greatest weakness of this strategy was exposed. When you double down, you are doubling your position to average down your dollar cost per share. However, along with the doubling of your position comes the doubling of your risk. The strategy works well when your stock rebounds, but not so well if the stock price continues going lower.

Once the bubble burst, many investors not only felt the sting of not being able to recoup their initial loss, but got hit with additional losses after they "doubled down" and their stock continued to trade down.

Let’s look back at our example. Above, we purchased 500 shares of XYZ for $40.00 and the stock traded down to $30.00 leaving us with a $5,000 loss. We then purchased 500 more shares in a double down strategy to lower our average cost. We now own 1000 shares at an average cost of $35.00.

Now let’s say that instead of the stock rebounding, the stock continues to fall to $25.00. The original purchase of XYZ at $40.00 has netted us a $15.00 per share loss for a total dollar loss of $7,500. But we also have to account for the additional 500 shares we bought at $30.00. This amounts to a $5.00 per share loss on 500 shares for an additional loss of $2,500. This brings our total loss to $10,000!

As you can see, “doubling down” doubles your position both on the way up and on the way down. It can help eradicate losses but can just as quickly multiply them.

So what can an investor do?

ASSIGN: To designate an option writer (seller) for fulfillment of his obligation to sell stock (call option writer) or buy stock (put option writer). The writer receives an assignment notice from the Options Clearing Corporation (OCC).

CALL: An option which gives the owner the right, but not the obligation, to buy the underlying security at a specified price for a certain fixed period of time.

CLOSING TRANSACTION: A trade which reduces or decreases the net position of an investor.

CONTRA-HOUSE/CONTRA-SIDE: The “other person” in a transaction (i.e., the seller to your purchase or the purchaser of your sale).

DELTA: The first derivative of the stock. Delta has a three pronged definition. The first is percentage change. The delta number is given as a percentage, meaning how much in percentage terms the option price will change with a movement in the stock. A 50 delta option will move 50% the amount the stock moves. If the stock moves $1.00, than the option moves $.50. A 30 delta option moves $.30 on a $1.00 movement in the stock, and so on. Delta can also be defined as percentage chance. This is used to describe the percentage chance that the option will end up in-the-money. A 90 delta option has a 90% chance of finishing in-the-money. Finally, delta can also be defined as hedge ratio. The hedge ratio is the amount of equivalent stock needed to properly hedge a position.

DERIVATIVE: A product which derives (gets) its price based on the price of something else. In the case of options, an options price is derived from the underlying instrument on which the option is based (i.e. stock or other security).

EXERCISE: The action taken by an option holder that requires the writer to perform the terms of the contract. Call holders exercise to buy the underlying security, while put holders exercise to sell the underlying security.

EXPIRATION DATE: The day on which an option contract expires. The expiration date for stock options is the Saturday following the third Friday of the expiration month.

EXTRINSIC VALUE: The price of an option less its intrinsic value. In the case of out-of-the-money options, the option’s entire price consists only of extrinsic value. Extrinsic value is made up of several components, with the largest being volatility. Also known as Time Value.

HOLDER: The buyer of an option. Also known as the owner.

IN-THE-MONEY: An option is considered to be in-the-money when, in the case of a call, the call’s strike price is lower than the price of the stock. In the case of a put, a put is considered to be in-the-money when the put’s strike price is higher than the price of the stock.

INTRINSIC VALUE: The value of the option in relation to the price of the underlying security. For call options it is the difference between the stock price and striking price, if that difference is a positive number, or zero otherwise. For put options it is the difference between the striking price and the stock price, if that difference is positive, or zero otherwise. Only in-the-money options have intrinsic value.

LONG: Generally refers to ownership. The number of contracts or shares in a particular series, class or underlying stock an account possesses. Any position (stock, option, or combination of) whereby the holder of the position profits from an increase in the price of the stock.

NAKED: The term naked signifies any position that is not hedged. For example, “naked stock position” would indicate that the investor has a stock position with no form of hedge (calls, puts) against it.

OPTION: A derivative product that gives the owner the right, but not the obligation to by a specified security, at a specified price, by a specified date. The seller, on the other hand, is obligated to buy or sell a specified security, at a specified price, by a specified date.

OPTION SERIES: All option contracts on the same underlying stock having the same price, expiration date and unit of trading.

OPTION CLASS: A term used to refer to all put and call contracts on the same underlying security.

OPENING TRANSACTION: A trade which creates or increases the net position of an investor.

OPTION BUYER: The individual who obtains the right but not the obligation to exercise an option.

OPTION SELLER: (Writer) The individual who is obligated, if and when he is assigned an exercise, to perform according to the terms of the option.

OUT-OF-THE-MONEY: A call option whose strike price is above the market price of the stock, or a put option whose strike price is below the market price of the stock.

PARITY: A condition which exists when the premium for an option consists strictly of intrinsic value. The amount by which an option is in the money.

PUT: An option granting the owner the right, but not the obligation, to sell the underlying security at a certain price for a specified period of time.

SHORT: Generally refers to the selling of an option contract that is not previously owned. This term is used to designate the position the option seller has after he has written an option. Any position (stock, option, or combination of) whereby the holder of the position profits from a decrease in the stock price.

STRIKE PRICE: The price at which the owner of the option may buy or sell the underlying security. Similarly, it is the price at which the seller of the option must buy or sell the underlying security and is also known as the Exercise Price.

TIME VALUE: The part of an option premium that is in excess of the intrinsic value.

PREMIUM: The total amount paid for an option.

TIME DECAY: The rate by which an options extrinsic value decreases over time.

UNDERLYING: The stock, commodity, currency, cash index or other security to be delivered in the event that an option is exercised.