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Profit and loss are a part of the trading game. You are not a real trader if you haven’t suffered a loss. You can own the loss, learn from it, and get working on improving the trade or you can back out, blame it on luck, and exit the stock market forever. The choice is yours. Here are the two best ways to successfully recoup losses.
Trade Gone Wrong? Here Are The Two Best Ways To Successfully Recoup Losses
Handling a Loss-making Trade
Every stock or commodity you buy is subject to volatility. It is this volatility that creates opportunities as well as risks. While we always look at opportunities to buy the dip and sell the rally, we often overlook the risks or downsides that volatility brings. What if you purchased the stock at a high price and now the stock is falling?
Your loss is only rising 20%…25%… 50%. That is a trade gone wrong, probably because your original analysis no longer holds. It happens with everyone, even Warren Buffett. Hence, when the pandemic struck, he didn’t even blink and sold US$6 billion worth of airline stocks for a loss. His original analysis of operational efficiency no longer held. Sometimes you got to own your trade and book that loss. There are many ways of handling losses as an investor and a trader.
You can take some time, think about what you could have done differently, reiterate the whole scenario, and draw strategies that could reduce your cost or learn from repair strategies and option fixes.
An investor who has suffered a substantial loss from a long position, generally opts for three options to handle the loss:
Sell and book a loss as Buffett did with airline stocks. You can offset this loss with profits from another stock.
Hold with the hope for the stock price to recover. Many investors are hodling Bitcoin with hopes for growth.
Or double down by buying more shares at the dip, hoping for the share price to revive.
But there is a repair strategy that involves buying and selling call options. If you want to fix your trade, you have to act fast and not wait until the loss is too deep to be fixed.
A Strategy to Reduce Losses from a Wrong Trade
You have purchased a stock at a higher price, and now the stock is falling. The bigger the loss, the longer it will take for any strategy to fix it. First, let’s understand the strategy to fix a long position. Then determine how much loss the strategy can recoup.
When your stock is losing value, you can purchase one in-the-money (ITM) call option with a high premium and offset the premium cost by selling two out-of-the-money (OTM) call options with the same expiration date. The ability of this strategy to recoup loss lies in the strike price.
For instance, you purchased 100 shares of Lightspeed Commerce at $70 at the start of the year, but it has now fallen to $50. It’s time to recoup losses before it falls further. So you buy ITM call options with a $50 strike price. If the stock price rises, you will have the option to buy 100 shares at $50 each, thereby reducing your average cost to $60 for 200 shares.
You sell two call options at the strike price, which is 50% of your loss. In this case, your loss is $20 per share. So your strike price should be $50 + $10 (50% of the loss), which is $60. If the stock price increases beyond $60, the buyer will exercise the option and buy 200 shares for $60 each, and you will recoup all your losses.
This strategy is dependent on the stock price growth, which was dependent even when you were long on the stock. This strategy reduces the breakeven point beyond which the options need to be exercised. In the above case, you reduced your breakeven from $70 to $60. But this strategy is effective in losses between 10% and 50%.
A Long Stock Fix
If the above repair strategy looks confusing, you might want to try a simpler fix, a ‘covered call’. In this strategy, you sell a call option on the shares you purchased at the same strike price you bought them. So your call option is covered by the shares you own. This strategy also looks to mitigate losses with the options premium money.
For instance, you bought shares of Lightspeed at $80, and they fell to $75. And you don’t see any immediate upside as the company fights Spruce Point’s allegations. So you sell a call option on the stock with an $80 strike price for $5. This way, you recoup the loss. If the stock continues to fall at expiration, the call option goes unexercised, and you keep the premium.
You can sell another call with a $75 strike price for a $5 premium and further reduce your average cost. You can continue doing this as long as Lightspeed stock trades below the strike price. But if the stock price rises, you can do two things.
Either you can execute the call option and sell the stock at the strike price
Or you can buy back the call option at a higher price than you sold it for and keep the shares.
Which of the two options you will choose depends on how bullish the sentiment is around the stock and what is your take on the share price. If you believe Lightspeed has a strong upside and that it can surpass the $80 price at which you purchased the stock, then it is better to buy back the call option.
Remember, trade loss is real. Even if you try to repair the loss, it is a new trade. Whenever you do a new trade to recoup losses, see if your original analysis on the asset still holds, as the turn of events could make a winning stock lose. Your analysis will determine the repair strategy.
Don’t fear losses but embrace them in a way that makes you a better and well-learned trader.