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Nov

15

Trading Options - Buy-Writes

Filed Under Beginner Options Trading 

Buy-Writes
There is a special order that allows traders to enter into a covered call as a “package deal” to the market maker, which is called a buy-write. With a buy-write, you can send an order to “buy” the stock and simultaneously “write” (sell) the call, which can be executed “at market” or as a “limit order.” Regardless of how the order is placed, any executed order results in a net debit (because the stock must always be more valuable than the call). Since you’re giving the market maker two trades rather than one, you will generally get a little better price for the package deal and every little bit helps.
 
Are Net Debits Confusing?
Sometimes new traders have trouble with the concept of net debits but it’s very similar in concept as when you negotiate with a car dealer to trade in a used car for a new one. If the dealer is asking $30,000 for a new car and you would like to receive $10,000 for your used car then there is a $20,000 difference between the two prices. You may, for example, try to make a deal by telling the dealer that you want to buy the new car by trading in your used car plus $18,000 cash. In other words, you’re telling the dealer you want to buy one asset and sell another for a net payment or “net debit” of $18,000. It’s should be of no concern to you if the dealer says he cannot sell the new car below $30,000 but is willing to give you $12,000 for your trade-in since that is still a net payment of $18,000 to you. Car dealers often work with the differences between the two cars.
 
This is exactly the idea behind the net debit with buy-writes. When you enter a buy-write, you’re telling the market maker that you don’t care what price they charge you for the stock or what price you receive for your calls as long as it is executed for a price less than or equal to your net debit limit.
 
The simultaneous execution of both positions eliminates execution risk, which is the result of adverse price movements. For example, assume the stock is $50 and you wish to buy the stock and then sell a $50 call, which is trading for $3. Notice that this means you are expecting to end up with a net debit of $47 for the two trades. However, if you place an order to buy the stock at market, you may get filled at a little higher price than $50, say $50.25. Then you immediately place the order to sell the $50 call and the stock’s price suddenly drops, which makes the call price $2.90. Because of the adverse price fluctuations, you paid more for the stock and received less for the call and end up with a net debit of -$50.25 + $2.90 = 47.35 instead of the expected $47. If you enter the two trades as a buy-write, you will not face this adverse movement. If the stock’s price suddenly jumps higher while the order is being executed, you’ll pay more for the stock but will also get more for the call. If the stock price drops lower during execution, you’ll get less for the call but also pay less for the stock. The result is that the net debit should stay pretty close to the same and not leave you with any unwanted surprise fills.
 
Incidentally, there is a mirror-image trade that allows the investor to simultaneously get out of a covered call, which is called an unwind. If you unwind a covered call, you will sell your stock and simultaneously buy back the call option. As before, the reason for doing both transactions simultaneously is to prevent execution risk. Most brokerage firms that offer buy-write screens also have unwind screens available online. If you are an avid covered call writer, you should strongly consider using the buy-write and unwind transaction screens if you are buying the shares at the same time you are writing the calls.
 
At the beginning of this chapter, we said that investors can write calls against shares they have been holding in the account. This is usually called overwriting and generally leads to a conservative use of covered calls since the investor is obviously willing to assume the downside risk. The buy-write, however, is typically used as a one-time strategy for the sole purpose of writing the call, which is a speculative use of covered calls. The buy-writer’s philosophy is usually (not always) to find a high option premium and then buy the stock and simultaneously write the call. After all, why would he need to buy the stock at that same moment? The answer is that he usually wishes to capture a premium-rich option and must buy the stock to cover the upside risk. Entering the orders together as a buy-write gives these investors a little added edge.
 
While buy-writes are generally speculative, they do not have to be. Some investors, as we discussed previously, may be perfectly comfortable holding a certain stock but wish to write in-the-money calls to provide for a bigger downside hedge. These investors often do end up getting assigned and losing the shares. Buy-writes can be a cost-efficient way to continually enter into new trades.
 
Regardless of whether or not you are comfortable assuming the downside risk, the buy-write can add a little edge for those times when you wish to buy the stock and write the call in the same transaction. You may wish to check with your broker to see if they offer a “buy-write” screen and get in the habit of using it whenever you wish to enter the two trades simultaneously. If you are entering buy-writes, just be certain that you have properly identified your reason for buying the stock. If it is purely for the ability to write the call, then understand that it is a speculative investment and adjust the size of your trade accordingly.
 
 
 
Roll-Outs
We learned earlier that it doesn’t really matter if the stock price rises above the strike of the short call at expiration since this is the maximum gain portion of the profit and loss curve. While it may not be the ideal situation, it is not a losing situation by any means. When this happens, most investors feel they only have two choices. First, they can let their shares get called away. Second, they can buy back the call and end up with an unrealized gain in the stock. However, there is a third and often overlooked strategy available, which is called a roll-out.
 
Assume that AGIX is $21 at expiration and the October $20 call that you sold is trading for $1 intrinsic value and November $20 call is trading for $3. You could buy back the October $20 call and simultaneously sell the November $20 call for a net credit of $2. In other words, you have rolled out to the following month. Effectively you sold another $20 call for $2, which again lowers the cost basis of your stock by the same amount.
 
Of course, you could choose to sell other strikes as well. If, instead, you sold the November $25 call you would be rolling out and up (rolling out in time and up in strikes). This strategy is used when the stock makes a significant upward move. For example, assume AGIX is trading for $25 at October expiration and the $20 call you sold is trading for the $5 intrinsic value. Further assume that the November $25 call is trading for $3. You could buy back the October $20 call and sell the November $25 call for a net debit of $2. Effectively, you have paid $2 for the chance to make an additional $3 (the difference in strikes less the $2 paid) if AGIX is above $25 at expiration.
 
In our example, you had a cost basis of $14.41 on the stock. If you buy back the $20 call and sell the $25 call then your cost basis increases by $2 to $16.41. You could make a maximum of $25 for a net gain of $8.59, which is $3 more than your previous gain. Rolling out or rolling up trades are collectively known as rolling trades and they allow investors to make another investment based on the same shares that are already in the account. If you don’t want to let go of your shares, you can always execute a rolling trade. The important point is that you make your decision based on sound objectives rather than rolling up just because you don’t want to see your stock taken away.
 
 
Roll-Downs
A roll-down is the reverse of a roll-up. With roll-downs, the investor buys back the existing strike but sells a lower strike call against the shares. Investors are often forced to do this when the stock price falls since the higher strike price may be trading for too low of a price to make it worthwhile. For example, assume AGIX is trading for $15 at expiration. The October $20 call you sold is close to worthless, but you may find that the November $20 isn’t commanding much of a premium either. You could execute a simultaneous order to buy back the October $20 call and sell the November $15 call.
 
The problem with writing the $15 call is that it reduces the potential sales price of the stock. By selling the $15 calls, you have the potential obligation to sell your shares for $15, which means the potential sales price is reduced by five dollars. You will always reduce your potential selling price when you roll down. For example, assume you can buy back the October $20 call and sell the November $15 call for a net credit of $2. Your cost basis on the stock is reduced from $14.41 to $12.41 but now you have the potential obligation to sell your shares for $15. In this case, the roll-down worked out okay but, depending on the cost basis of the stock you could lock yourself into a potential loss if assigned. For instance, if your cost basis on the stock was $18 and you rolled down for a net credit of $2 then your cost basis is $16 but you may have to sell the shares for $15.
 

Remember that the covered call strategy is a neutral to slightly bullish strategy. If the stock price is falling then you may be in the wrong trade and it’s usually not the best idea to try to “write” your way out of the loss by selling lower strike calls. In most cases, you just end up digging a deeper hole. But depending on your cost basis it can be a viable trade, so it’s worth understanding.

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