Joined Oct 2007
L2: Beginner
Forum Thread
Options Trading for Fun and Profit: The Buy-Write
April 4, 2011 at
06:33 PM
Thread Details
<strong>By: slickdealer <a href="https://slickdeals.net/forums/member.php?u=751329">dittyesq</a></strong>
<p style="text-align:center;"><a href="http://www.flickr.com/photos/35237099579@N01/2178059797/"><img class="aligncenter" src="http://farm3.static.flickr.com/2249/2178059797_a5430f7d80.jpg" alt="" /></a></p>
<p style="text-align:center;">Image by Flickr user <a href="http://www.flickr.com/photos/mikeleeorg/">Mike Lee</a></p>
A few months back, I received a phone call from the friendly folks at Morgan Keegan, inviting me to drop by my local Regions Bank (Regions owns the MK brokerage) and chat about "stock options." Not the kind of stock option that corporate CEOs get bundled with their paychecks, mind you -- the brokers had another "option" in mind.
What they wanted to talk about was the kind of option that gives a person the right to buy or sell (i.e., the "option" of buying or selling) a stock at a specified price on a specified date in the future. It's a bit of a complicated subject, but Morgan Keegan was offering to tell me all about it, for free.
Now, as a do-it-yourself investor, I admit to being leery when a banker calls me up and offers to do me a favor. Still, out of morbid curiosity, I agreed, figuring at worst I would lose a half-hour of my time (90 minutes turned out to be more accurate.) At best, I might learn something. And here begins our tale…
<strong>Consider your options</strong>
At this point, a couple definitions are probably in order. Broadly speaking, options fall into one of two categories. A "put" option gives the owner the right to force someone else to buy shares at a certain price. Conversely, a "call" option allows its owner to compel someone to sell them stock at a certain price. The reason both options exist is that, sometimes, you might want to sell shares for more than they're worth. Other times, you want to buy shares for less than they would otherwise cost. Either way, the point is the same: You want to make a profit, and options are one way to do it.
Morgan Keegan's favored strategy on this particular day was something called a "buy-write," which consists of two parts. First, you buy a stock. Then, you "write" (i.e. "sell") someone else a call option on the stock. (Remember, when you sell a "call," you are agreeing to let someone else demand that you sell it later on, at a specified price.)
<strong>What's in it for me?</strong>
Now, why would you do this? Three reasons: First, when you sell a call option, you get paid for it. Second, when you buy a stock, up until the time the call option is invoked, you get to collect any dividends the stock pays. (So now you've been paid twice.) Third and finally, it's entirely possible that by the time the call option expires, the person who bought your call option will decide not to exercise it. In that case, you get to keep the money you were paid for the option, you get to keep the dividends, and you get to keep the stock. Win-win-win.
Sound too good to be true? It did to me. I figured there had to be "a catch." And so, as soon as I escaped the bankers, I ran right home and began crunching numbers. Here's how it works, using GE as an example:
• GE sells for $$20 today.
• It pays $0.14 per share in quarterly dividends.
• You can sell someone the right to "call" the stock (make you sell it to them) for $20 per share, any time between now and June 18, 2011, for about $1.
So assume you buy a share of GE, and simultaneously sell a covered call (i.e. a call option on something you own) today. You pay $20, collected $1 for your call, and then collect a $0.14 dividend at the end of this quarter (April 24, to be precise.)
$20 - $1 - $0.14 = $18.86. So you are effectively buying a $20 share of GE for a 5.7% discount from today's share price.
Now let's look at three scenarios. On June 18, 2011, GE is either:
• …still selling for $20. The call option expires worthless. You have earned almost 6% in less than three months (not bad when you consider it could take a full year to earn just 1% in a bank account.) You still own the GE stock.
• …up 20%, selling for $24. The call option is exercised (because it is cheaper to force you to sell the stock for $20 than to buy it for $24 on the open market). Again, you have earned nearly 6% in three months -- but you no longer own the stock.
• …down 20%, selling for $16. The call option expires worthless. (No one wants to force you to sell them a stock for $20 when they can buy it on the open market for $16. You have lost 15%. You still own the GE stock.
So in scenario 1 you made a good profit on a "dead money" stock. In scenario 2, you made good money, too -- albeit not as good as someone who just bought GE stock without the bells and whistles. That guy made 21% in three months ($24 when he sold the stock, plus $0.14 in dividends received), or an 84% annualized return! In scenario 3, you lost money, but didn't take as bad a hit as the guy who just bought GE stock did. He has a $4 loss, mitigated somewhat by $0.14 in dividends, which works out to a 19% loss.
<strong>Putting it all together</strong>
So in essence, the Buy-Write idea seems to be this: Two times out of three, you make good money. That third time, you at least "lose less than the other guy."
To me, this seems a plan aimed at reducing volatility, maximizing your chance at earning good-not-great returns (when your stock zooms, you miss out on most of the profits), and reducing the pain of a drop in stock price. It's probably best suited for someone with a relatively low "pain" threshold. It also gives you a way to produce extra income from owning a stock (every time you sell an option, that's money in your pocket.)
Personally, I doubt I'll be taking Morgan Keegan up on their offer. To me, "buy-write" seems like too much work to be worth the modest returns it promises. I'll stick with my usual strategy of just buying cheap stocks, and not buying expensive ones. But hey -- it never hurts to know there are other options out there.
<em>International lawyer by day and Slickdealer by night, Rich Smith is always on the lookout for a good bargain. Helping corporations pillage Third World economies is great for paying the mortgage, but Rich's real loves are writing about stock investing for The Motley Fool, buying cheap stocks for his own portfolio, and strolling the aisles at Slickdeals in search of the ultimate blue-light special. A veteran of Moscow, Kiev, and Washington, D.C., Rich has traded-in city life, and now takes his ease in the fields of rural Indiana.</em>
<p style="text-align:center;"><a href="http://www.flickr.com/photos/35237099579@N01/2178059797/"><img class="aligncenter" src="http://farm3.static.flickr.com/2249/2178059797_a5430f7d80.jpg" alt="" /></a></p>
<p style="text-align:center;">Image by Flickr user <a href="http://www.flickr.com/photos/mikeleeorg/">Mike Lee</a></p>
A few months back, I received a phone call from the friendly folks at Morgan Keegan, inviting me to drop by my local Regions Bank (Regions owns the MK brokerage) and chat about "stock options." Not the kind of stock option that corporate CEOs get bundled with their paychecks, mind you -- the brokers had another "option" in mind.
What they wanted to talk about was the kind of option that gives a person the right to buy or sell (i.e., the "option" of buying or selling) a stock at a specified price on a specified date in the future. It's a bit of a complicated subject, but Morgan Keegan was offering to tell me all about it, for free.
Now, as a do-it-yourself investor, I admit to being leery when a banker calls me up and offers to do me a favor. Still, out of morbid curiosity, I agreed, figuring at worst I would lose a half-hour of my time (90 minutes turned out to be more accurate.) At best, I might learn something. And here begins our tale…
<strong>Consider your options</strong>
At this point, a couple definitions are probably in order. Broadly speaking, options fall into one of two categories. A "put" option gives the owner the right to force someone else to buy shares at a certain price. Conversely, a "call" option allows its owner to compel someone to sell them stock at a certain price. The reason both options exist is that, sometimes, you might want to sell shares for more than they're worth. Other times, you want to buy shares for less than they would otherwise cost. Either way, the point is the same: You want to make a profit, and options are one way to do it.
Morgan Keegan's favored strategy on this particular day was something called a "buy-write," which consists of two parts. First, you buy a stock. Then, you "write" (i.e. "sell") someone else a call option on the stock. (Remember, when you sell a "call," you are agreeing to let someone else demand that you sell it later on, at a specified price.)
<strong>What's in it for me?</strong>
Now, why would you do this? Three reasons: First, when you sell a call option, you get paid for it. Second, when you buy a stock, up until the time the call option is invoked, you get to collect any dividends the stock pays. (So now you've been paid twice.) Third and finally, it's entirely possible that by the time the call option expires, the person who bought your call option will decide not to exercise it. In that case, you get to keep the money you were paid for the option, you get to keep the dividends, and you get to keep the stock. Win-win-win.
Sound too good to be true? It did to me. I figured there had to be "a catch." And so, as soon as I escaped the bankers, I ran right home and began crunching numbers. Here's how it works, using GE as an example:
• GE sells for $$20 today.
• It pays $0.14 per share in quarterly dividends.
• You can sell someone the right to "call" the stock (make you sell it to them) for $20 per share, any time between now and June 18, 2011, for about $1.
So assume you buy a share of GE, and simultaneously sell a covered call (i.e. a call option on something you own) today. You pay $20, collected $1 for your call, and then collect a $0.14 dividend at the end of this quarter (April 24, to be precise.)
$20 - $1 - $0.14 = $18.86. So you are effectively buying a $20 share of GE for a 5.7% discount from today's share price.
Now let's look at three scenarios. On June 18, 2011, GE is either:
• …still selling for $20. The call option expires worthless. You have earned almost 6% in less than three months (not bad when you consider it could take a full year to earn just 1% in a bank account.) You still own the GE stock.
• …up 20%, selling for $24. The call option is exercised (because it is cheaper to force you to sell the stock for $20 than to buy it for $24 on the open market). Again, you have earned nearly 6% in three months -- but you no longer own the stock.
• …down 20%, selling for $16. The call option expires worthless. (No one wants to force you to sell them a stock for $20 when they can buy it on the open market for $16. You have lost 15%. You still own the GE stock.
So in scenario 1 you made a good profit on a "dead money" stock. In scenario 2, you made good money, too -- albeit not as good as someone who just bought GE stock without the bells and whistles. That guy made 21% in three months ($24 when he sold the stock, plus $0.14 in dividends received), or an 84% annualized return! In scenario 3, you lost money, but didn't take as bad a hit as the guy who just bought GE stock did. He has a $4 loss, mitigated somewhat by $0.14 in dividends, which works out to a 19% loss.
<strong>Putting it all together</strong>
So in essence, the Buy-Write idea seems to be this: Two times out of three, you make good money. That third time, you at least "lose less than the other guy."
To me, this seems a plan aimed at reducing volatility, maximizing your chance at earning good-not-great returns (when your stock zooms, you miss out on most of the profits), and reducing the pain of a drop in stock price. It's probably best suited for someone with a relatively low "pain" threshold. It also gives you a way to produce extra income from owning a stock (every time you sell an option, that's money in your pocket.)
Personally, I doubt I'll be taking Morgan Keegan up on their offer. To me, "buy-write" seems like too much work to be worth the modest returns it promises. I'll stick with my usual strategy of just buying cheap stocks, and not buying expensive ones. But hey -- it never hurts to know there are other options out there.
<em>International lawyer by day and Slickdealer by night, Rich Smith is always on the lookout for a good bargain. Helping corporations pillage Third World economies is great for paying the mortgage, but Rich's real loves are writing about stock investing for The Motley Fool, buying cheap stocks for his own portfolio, and strolling the aisles at Slickdeals in search of the ultimate blue-light special. A veteran of Moscow, Kiev, and Washington, D.C., Rich has traded-in city life, and now takes his ease in the fields of rural Indiana.</em>
About the OP
17 Comments
Your comment cannot be blank.
Sign up for a Slickdeals account to remove this ad.
What you explained is more commonly referred to as a "covered call" altho the term buy-write is correct. You "buy" blocks of 100 shares of a stock and sell or "write" the option call for same.
Keep in mind, market direction. A safer way to make a small percentage each month in a runaway bull market is to sell a "put'" on the stock which is also covered because you own the stock. Right now puts are much less likely to pay ... which is what the stock owner/writer/seller wants.
After mentioning puts it is still more risky IMHO to sell them.... a catastrophic market slide caused by some world event would ruin a put seller. Selling calls has that upside risk but I've never seen a market crash "UP" ... have you? Wish I didn't know this lesson so well - 9/11 comes to mind.
Selling covered calls in a mildly bullish or dormant market is the ideal setup .... you would make money each month from your crop of expired options.... can't do that with just stock. Most options, be they calls or puts expire worthless .... I'm betting on it.
Sign up for a Slickdeals account to remove this ad.
BTW I would never sell a naked option be it a put or a call - this is a recipe to turn a small fortune into NO fortune.
BTW I would never sell a naked option be it a put or a call - this is a recipe to turn a small fortune into NO fortune.
This is to my understanding.
If you own the stock and then sell puts on the same stock (which I think you listed in my quote above), the stock DOES NOT hedge your puts you are selling. Those are essentially NAKED PUTS because if the market goes down you will be given the stock at the strike price of the puts.
Maybe you were referring to buying puts against stock you own - that would hedge/protect the downside.
If you own the stock and then sell puts on the same stock .... if the market goes down you will be given the stock at the strike price of the puts.
if you sell the put, and the stock on which you wrote the put tanks below the exercise price, whoever bought the put will sell the stock to you at the put strike price. so basically if you had the same stock as well, it's like double whammy (leveraged up) as you end up holding two tanking stocks now....
i don't quite see how this set-up is COVERED, as you are 'double' naked on the downside
You own 100 shares of stock and buy a put, (neutral position) you are hedging against a decline in the price of that stock or trying to protect new profits after price escalation.
You own 100 shares of stock and sell a put, (bullish) you are trying to supplement your income if/when that put expires worthless. Your profit is the selling price of that put when it expires.
You own 100 shares and buy a call - (double bullish) not usually done but it's a free country.
You own 100 shares and sell a call - (bearish) this is the one most refer to as a covered call. You are betting that the price either does nothing, goes down a bit or goes up a bit but not hi enuf to reach the strike price. You profit from sale price of expired call.
All above examples start with "you own the stock" - For each block of 100 shares you can only sell 1 call or put contract. This makes them all "covered" meaning if something really bad happens, the 100 shares exists in your acct ready to be taken from you.
Naked puts or calls do not have 100 shares to back up what you do. Instead you must have liquidity - most online brokers will not let you even begin naked option selling unless you have a minimum of 100K cash in acct. and can prove you know what you are doing. In that light if you DO know what you are doing, you are not messing with naked option selling exclusively.
Remember, unless you strictly follow IRS publication 550 (http://www.irs.gov/pub/irs-pdf/p550.pdf) for selling qualified covered calls, you will be creating straddles for tax purposes.
This is not a straddle as we define it in options lingo, but a tax straddle is a set of offsetting positions where one position limits the risk on another.
In the case of the idea mentioned by the OP in this thread, the 100 units of the shares owned will protect against the risk of the short call position in case the share price shoots upwards. Hence, this is a straddle, for tax purposes and when filing taxes, involves convoluted record keeping and additional forms (took me approximately 10 hours of reading time and record keeping with about 120 trades over the year). In addition, your holding period for the long stock is suspended or completely nullified (in case you are trying to hold the shares for 1 year to get long term cap gains when you sell).
I've been investing profitably for close to 15 years now, but the intricacies of options still give me a headache...