Covered Call – Buy Write Strategy
By Matthew Brown
Matthew Brown is an Authorized representative (Authorized Rep number 319961) of Halifax Investment Services Limited (AFSL 225973)
The following document is an excerpt from the Covered Call article published on the FMR Analysts website. Click Here to go directly to the complete article.
Article Contents:
1.0 Introduction 3
2.0 Strategy Outline 3
3.0 Terminology 4
4.0 Selling Options 5
5.0 Covered Call 6
6.0 Buy Write 6
7.0 Breakeven, Profits and Losses 7
8.0 Why Write a Covered Call Option? 8
9.0 Time Decay 9
10.0 Which option to write? (OTM, ITM, ATM) 9
11.0 Volatility 13
12.0 Risks of writing a covered call 13
13.0 Margins 15
14.0 Assignment/Exercise 15
15.0 Covered Call/Buy Write guidelines 16
16.0 Analyzing for a Covered Call/Buy Write position 17
17.0 Placing orders 22
18.0 Exiting 23
19.0 Roll-up/Roll-down/Roll-out 26
20.0 Covered Call/Buy Write don’ts 30
21.0 Trader Tips 31
22.0 Case Studies 31
23.0 Resources 36
24.0 Books 36
25.0 Disclaimer 36
1.0 Introduction
In the “Creating Income from Stock using Options” article, we introduced the concept of Writing Options with the strategy of Covered Calls, or the alternative strategy, the Buy Write.
We will further explore these strategies throughout this document, analyzing and evaluating how to choose a stock, what option to write, and what action to take.
The Covered Call, or Buy Write strategy, is one of the best option strategies for beginners to ease into using Options. Instead of buying and selling options on a regular basis, you can use your existing stock positions to create an additional income, or purchase stock and write an option against it.
But before anyone begins writing calls against existing shares, or goes out and purchases shares to write options against, they should completely understand the pros and cons of the strategy. Knowing what action to take, how this will affect your position, and not panicking will make you a far more profitable investor.
2.0 Strategy Outline
Action: Purchasing stock and Selling (Writing) Call options
Expectation: Stock/Market will be Neutral/Mildly Bullish
Benefits: Produce additional income from Call premiums
Profit: Capped by the strike price of the written Call option
Loss: Limited to value of stock, but lower due to premium received for writing the Call option
Breakeven: Strike price – premium received
Time Outlook: Medium to long-term
Before discussing the strategy, we must first understand the components of the strategy. There are 2 actions required to hold a Covered Call/Buy Write position.
• First, we either own stock or must purchase stock.
• Secondly, we Sell an option against that stock.
Majority of investors are familiar with the concept of owning stock, so we will not discuss this function here. However, selling (or writing) options is a concept that not many readers might be familiar with. Let’s discuss the concept of Selling Options.
4.0 Selling Options
An Options contract is an agreement between 2 parties.
For every option transaction, there is a Buyer (known as the Taker), and a Seller (known as the Writer).
Takers will buy call options because they expect the underlying share price to rise. The option is cheaper than the stock, offering a Leveraged rate of return.
Writers sell call options for one of two reasons: 1) to offer limited protection, and 2) to earn additional income.
The function of selling an option is where an investor creates a contract and offers it for someone to buy. In this case, the contract is a Call option. Contracts are standardized, so the writer cannot choose the terms. The Option Clearing Corporation (OCC) is responsible for issuing and standardizing all US exchange traded options.
The definition of a Call contract is:
• The right to buy shares, at a set price, on or before a set date.
• The Buyer (Taker) has the right to this contract (and therefore the right to purchase shares), whereas
• The Writer (Seller) is obliged/committed to the contract (must sell shares to the Taker if Exercised)
• For the right of this contract, the Buyer (Taker) pays the Writer (Seller) a premium.
Example
Investor A wants to buy MSFT shares. Investor B owns MSFT shares. Currently, the price of MSFT is trading at $35.00 per share.
Investor A likes the price of $35, but does not have the money to purchase the shares right now. Investor A will have the money to purchase 100 shares in 3 months time, and so decides to purchase a MSFT 3-month $35.00 Call option which is trading at $0.70 per share.
Investor B owns MSFT shares and had purchased them at $25. Investor B is unsure if MSFT will continue to rise over the next 3-months, and decides to write (sell) the MSFT 3-month $35.00 Call Option to offer limited protection.
The option contract is sold to Investor A for $0.70 per share.
Investor A, who has paid (taken/bought) for the option contract, has the right, but not the obligation, to purchase the shares if he wishes to exercise the contract. Investor B must fulfil that contract if Exercised, selling 100 shares at $35.
Investor A: has bought a contract to Buy 100 MSFT shares at $35 within 3-months.
Investor B: must sell 100 MSFT shares at $35, if the call option is Exercised, but has received $0.70 per share.
For share owners, you can write a Call option, receive Premium (income) for the contract, and establish a sell price for the future. This lowers your average purchase price (due to the premium received), but locks you into a maximum sell price (in this example $35).
Writing options carries risk. The Call option contract could be Exercised and you would need to offer up shares. If you did not own shares, you would have to purchase them at market price (this is known as Naked Writing and is high Risk), which could result in a greater loss than the premium received.
If you require more information about how an option contract is used, we suggest reading the “Options Explained” article found on the FMR Analysts website: Click Here to go to the site.
5.0 Covered Call
The Covered Call strategy is simple. If you own stock, you can write Call options against them.
A covered call is a strategy where the investor buys stock and then sells a call against it. By selling the call, you are giving the Taker (buyer) the right to buy your stock at a fixed price. It is referred to as “Covered” because the written call option is covered by you owning the stock.
You receive Premium for writing this option, which is the main benefit of conducting the strategy.
For example:
You own 100 shares in MSFT company. You had purchased them at $25 per share.
You write 1 x $25 Call option against MSFT, receiving $0.70 per share (there are 100 shares per contract)
This means you have paid $25, but received $0.70. Therefore, your average purchase price (or breakeven level), is $24.30 per share.
6.0 Buy Write
The Buy Write strategy is exactly the same as a Covered Call position, except, you do not own the shares to start with. To enter into the strategy, you need to purchase the shares and write the option at the same time.
The only difference between the Buy Write and the Covered Call is your evaluation of profit and breakeven levels. For the Buy Write, you calculate your profit and breakeven based on the current stock/option prices, while the Covered Call is evaluated based on the original purchase prices.
For all purposes throughout this article, except where indicated, when referring to a Covered Call, we will also be referring to a Buy Write position.
Traders Tip:
23.0 Resources
The information contained in this article portrays all the basic information you require to understand options. However, your understanding may not yet be completely clear.
Most of the information you will need to completely understand options is available for free on the internet. FMR Analysts has researched the best resources for you to complete your learning of options.
Chicago Board Options Exchange – Learning Centre
Go straight to the exchange to learn about options. At the CBOE online Options Institute, you can:
View self-guided online tutorials
Conduct self-paced interactive online courses
Watch live interactive educational webcasts, or
Book to attend a live seminar.
http://www.cboe.com/LearnCenter/default.aspx
24.0 Books
There are many books written on options, and how to understand them. The following are selections FMR Analysts recommends for the beginner:
Options for Equity Investors
Author: Wendy Newton
The Secrets of Writing Options
Author: Louise Bedford
Options: A complete guide for Australian investors and traders
Author: Guy Bower
FMR Bookstore: http://fmranalysts.blogspot.com/2006/09/bookstore.html
25.0 Disclaimer
Trading involves risk of loss and may not be suitable for you. Past performance is no guarantee or reliable indication of future results. This advertisement is of the nature of general information only and must not in any way be construed or relied upon as legal, financial or professional advice. No consideration has been given or will be given to the individual investment objectives, financial situation or needs of any particular person. The decision to invest or trade and the method selected is a personal decision and involves an inherent level of risk, and you must undertake your own investigations and obtain your own advice regarding the suitability of this product for your circumstances. Please ensure you obtain and read the current offer documentation prior to acquiring the products advertised herein, so you are fully informed regarding the key risks and costs associated with these products.
Matthew Brown (author) is an Authorized representative (Authorized Rep number 319961) of Halifax Investment Services Limited (AFSL 225973)
Source: http://www.ArticlePros.com/author.php?Matthew Brown
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