Many investors are facing large losses in Netflix Inc. (NASDAQ:NFLX) and Amazon.com Inc. (NASDAQ:AMZN) after both companies reported disappointing earnings. Netflix’s cash cow DVD subscribers are leaving in droves, while Amazon’s profitability fell unexpectedly. In both cases, investors with no confidence in a recovery are best off selling to cut their losses, but those with some hope remaining have a few other options.
Covered Calls for Small Losses
Investors facing a small loss may want to consider writing covered calls. By selling call options at a break-even or higher strike price, investors can realize a profit from the option’s premium. These premiums can help offset any losses, while they will not be forced to sell unless the stock moves up to the break-even or higher strike price. And even then, the investor can roll out or roll up the position.
Here are some examples for each situation:
- Assuming a $90 break-even point for Netflix shares, an investor could write one 90 November 2011 call option and receive $238 in premiums. This will lower the investor’s effective break-even point to about $87.62.
- Assuming a $210 break-even for Amazon shares, an investor could write one 210 November 2011 call option and receive $998 in premiums. This will lower the investor’s effective break-even point to about $200.02.
Repair Strategy for Bigger Losses
Investors sitting on larger losses may want to consider the so-called repair strategy. Under this strategy, investors would purchase one at-the-money call option and writing two out-of-the-money calls for every 100 shares owned. The premiums realized from writing the two options partially or completely offset the price paid for the single call option, making this a cheap or free position to initiate.
Since the original 100 shares covers one of the calls written, and the purchased call option covers the second call written, the position is completely covered. Meanwhile, the upside from the call option purchased at-the-money adds leverage, while the entire position isn’t required to be liquidated unless the stock moves past the strike price at which the two out-of-the-money calls were written.
Here is an example in Netflix’s situation:
- An investor could purchase one at-the-money 75 June 2012 call for $19.35 per contract, while simultaneously writing two out-of-the-money 110 June 2012 calls for $7.41 per contract. The result would be a modest $4.53 cost and a new, lower break-even point.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.