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Assume that after you purchase a long call, the underlying stock moves lower. When the underlying stock moves lower, you will most likely be more concerned with the ability of the stock to move back higher, otherwise your long call will result in a loss. If you still think underlying stock will you can lower your breakeven point, and in most cases, you can do it at no cost.Therefore, you can repair your losing position and give it a chance for a profit if the stock recovers somewhat.
INITIAL POSITION
Long one 45 strike Call at $2.500
BRAKEVEN PRICE = STRIKE PRICE $45 + DEBIT PAID $2.50 = $47.50
A few weeks later, YHOO drops in price to $42.50 and your $45 Call is now worth $1.50. YAHOO will have to move all the way back to $47.50 for you to just break even on the trade. You still feel YAHOO will move back higher but most likely not all the way back above $47.50. Instead of taking the loss and closing the position, you can lower your breakeven point by rolling down into a bull call spread.
OPTION ADJUSTMENT
Assume that with a ABC at $42.50, a ABC $40 Call with the same expiration as your $45 Call is trading at $3.00. To roll down to a bull call spread, you sell two $45 Calls at $1.50 each for a total credit of $3.00 and simultaneously purchase the $40 Call for $3.00 for no additional cost. By selling two $45 Calls, you are closing your long $45 Call and opening another short $45 Call to combine with the long $40 Call. The credit from selling the two calls covers the cost of the long call and allows you to roll down into a lower strike bull call spread at no additional cost.
FINAL POSITION
Long one $45 strike Call and
Short one $40 strike Call,
Your new $40/$45 bull call spread has the same cost basis as your $45 call $2.50—because rolling down cost you nothing.
BRAKEVEN PRICE = LOWER STRIKE PRICE $40 + DEBIT PAID $2.50 = $42.50
ABC just has to move higher from its current price of $42.50 by expiration for you to realize a profit. For example, if YaHOO moves back to $45, you will have a profit of $2.50 for a return of 100% as opposed to a loss of $2.50 on your original position.
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