Average-Down for Free with Options!

Let's assume that you purcahsed 200 shares of a stock for $90 per share, and that the stock is now trading for only $80 per share. The stock will have to increase by 12.5% in order for you to reach the break even point. If you were to buy another 200 shares at $80, you could reduce your average price to $85, and the stock would only need to rise by 6.25% to reach the break even point. This is known as averaging-down. Unfortunately, it costs money. You would need to invest another $16,000 in order to reduce your average price to $85. At some point you will not have enough additional capital to invest.

Sometimes it is possible to average-down for free using options. Let's assume that it is April right now, and you take a look at the May options, which expire in 7 weeks time.

May $80 Call option has an ask price of $5.40
May $85 Call option has a bid price of $2.80

You could buy 2 contracts of the May $80 Call for a total cost of $1080 (not including commissions). This gives you the right to buy 200 shares at $80, but you haven't actually done it yet. Then you sell 4 contracts of the May $85 Call and bring in a total of $1120. You may be obligated to sell 400 shares at $85, should the stock rally above $85, before the options expire. The net result of these transactions is $40 in your pocket.

Now you must wait and see what happens to the price of the stock.

If it stays at $80, or falls further, the options did not help you at all, but at least they didn't cost you money.
If the stock price rises to $82 by the morning of the May expiration day, then your 2 contracts of the May $80 Call are worth $400. You can sell them, and pocket the $400. The May $85 Calls will expire worthless, so there are no further implications.
If the stock price rises to $85 by the morning of the May expiration day, then your 2 contracts of the May $80 Call are worth $1000. You can sell them, and pocket the $1000. You could also sell your 200 shares at $85, because with the $1000 that you earned, you have now reached the break even point. Alternatively, you can continue to hold the shares. The May $85 Calls will expire worthless, so there are no further implications.
If the stock price rises to $86 (or any price above $85) by the morning of the May expiration day, then you can allow both option contracts to be exercised. You will buy 200 shares at $80, but then immediately sell all 400 shares at $85. You have sucessfully averaged-down and sold out of a losing stock for free.

Buying and selling of options involves risk and is not suitable for all investors.