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Options Trading for Fun and Profit: The Buy-Write

Posted on Monday, April 4th, 2011 at 6:33 pm (17) comments

By: slickdealer dittyesq

Image by Flickr user Mike Lee

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…

Consider your options
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.)

What’s in it for me?
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.

Putting it all together
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.

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.