WHAT IS THE BUY-WRITE STRATEGY?
As a definition, the Buy-Write strategy is fairly straightforward: you buy a stock, and then sell or write a call option on that stock.
The Buy-Write strategy is typically used as an additional trading tool to help increase the income, or mitigate some of the loss, for a long term investment portfolio. In other words, if your investment method is to buy stocks and hold them for a long period of time, the buy-write strategy will either add income to your portfolio, or reduce the loss if your investments are trending downward in price. However, if stock prices rise, you may have a lower, overall return. This is due the upside of the Buy-Write strategy being limited to the strike price plus any premium received.
For example, holding onto stocks in the long run gives you three possible outcomes:
1. The stock goes up and you make money. The amount you make is the difference between what you bought the stock for, and its current, higher price.
2. The stock price stays the same. In this case, you didn’t make any money, but you didn’t lose any either.
3. The stock price goes down. The amount of money you lost is the difference between what you bought the stock for, and its current, lower price.
As an example: You buy 200 shares of stock for $10/share. You decide to write one call option for $2/share to expire in 30 days. Since one call option is worth 100 shares of stock, you now have half your portfolio subject to the call option. So what happens under your three possible scenarios in 30 days, which is the time period you selected for your call option?
1. The stock goes up. If the stock goes up $5, you now have 100 shares you paid $1,000 (100 shares x $10/share), and are now worth $1,500 (100 shares x $15/share). You also have 100 shares that you got to keep the $200 premium share for the call option (100 x $2/share), but had to sell the shares for $1,000, so missed out on an extra $300 on that portion of your portfolio. Overall, you ended up with $500 + $200 = $700. If you had not written the call option, you would have made: 200 shares x $15/share= $3000, less your initial $2000 investment, or a profit of $1000. With the Buy-Write portion of your portfolio, you are worse off by $300 than if you had simply held onto your long stock.
2. The stock price stays the same. For half of your portfolio, the profit is $0 since the price stayed the same at $10/share. For your 100 shares subject to the call option, since there was no movement in price, the option is not exercised. You get to keep the $2/share premium or $200 and you also still hold on to your shares. So your profit if your portfolio stock remains flat in price is: $200. If you had not written the call option, your profit would have been $0. With the call option, you are better off by $200 than you would have been if you had held onto your long stock.
3. The stock price goes down. If the stock price goes down $5, half your portfolio would now be worth 100 x $5= $500, or a $500 loss. On the other half of your portfolio, your call option would not have been exercised, so you still hold your 100 shares at $5/share for an additional $500 loss. However, you get to keep the call premium at $2/share or $200, so you end up with +$200 – $500 – $500 for an $800 loss. With the call option, you are better off by $200 than if you just held onto your long stock.
LET’S LOOK AT AN EXAMPLE USING JNJ:
July 25th, 2012
Buy 100 JNJ shares @ 67.80
Sell 1 Sept $67.50 Call @ $1.25
The total cost for this trade is $6,655 which is your initial breakeven point ($66.55 per share). The profit potential on this trade is $95 if JNJ is above $67.50 at expiry in August, which represents a return of 1.43% on your initial capital. Keep in mind also that JNJ pays a healthy 3.57% dividend, so if you are holding the stock over a dividend ex-date, you will also receive the dividend which can further increase your return. JNJ is due to pay a dividend in August.
Another variation on this strategy you can try is known as the buy delayed write, whereby you buy the stock, wait for it to rise and then sell your call. This can really increase your returns, but it does have risks. If the stock falls after your purchase you will get less premium when you do sell the call, or you will need to sell a call at a lower strike.
TRADE MANAGEMENT
If JNJ is above $75 at June expiry, you can let your shares be called away, take your profits and move on to the next opportunity. Or, if you are a long term holder of JNJ shares, you can buy back the sold call and write another call option.
If JNJ falls, you can either take your losses by selling the shares and buying back the call, or roll the call down to a lower strike. As part of your trading plan, you will need to have strict criteria as to what you will do in this situation. Most traders set an 8% stop loss where they will close the trade and walk away. However, if the stock has only fallen 5%, maybe that is a situation where you would look at rolling down the sold call to a lower strike.
Here’s to your ultimate success.
