Beware the Buy Write – Part 3

Day three of our hypothetical TPX buy write. For those of you who weren't watching yesterday, TPX rallied hard of its low around $27 to close up $.80 at $28.48 and has been holding those levels this morning. At one point today the market in the calls was $1.60 - $1.75 (the call is nearly $1 in the money) the stock was around $28.5 while the puts were $.65 - $.80. Notice that we could close the position and capture a $.32 profit or if you had sold the puts at $1.15 (remember it is the same position) you could lock in $.35.

Now realistically, when you establish the buy write, you have to have some expectation of an acceptable range of movement before a decision has to be made. If the stock starts having large ranges on a daily basis it can become pretty stressful, as any trader who has had large short gamma positions knows. But what we are focusing on is what choices we have and how to enact them now that we have this position on.

Let's say that after our hypothetical two week time frame, the stock is trading down about $2 from our purchase price of $27.42 with the calls now being worth roughly $.05 and having seven days left to expiration. The position has lost $1 net, not unexpected given the stock action, but I am fairly sure you didn't enter the trade to lose money (by the way if anyone out there is entering trades to lose money, let me know, I am available to take the other side). If this is a core position and/or you still have positive expectations for the stock, this may not be a big deal. This does not take decision making out of the picture. The call has given up 95% of its sale price and holding onto it for another week to squeeze the last nickel out of the deal may not be the most prudent choice, particularly if there is some potential catalyst before March expiration. Perhaps rolling the short call out to the Apr 27.5 Cs, or out and down to the Apr 25 Cs if you want to keep your "hedge" tight. The choice is yours here and should be consistent with your expectations. The point is that this was not a neutral to bearish strategy, but a purely neutral, low expectation of movement strategy with the ideal scenario as described in Part 2. This is true for any strategy that involves selling options; little movement is the ideal outcome.

I feel I am getting a little long winded for this post, so we will take a look at what happens when the stock finishes the two week time frame up $2 next time.

New Chart and Loading Times

Just added the new chart above, but it seems it may require some serious load times (powered by Silverlight).  FreeStockCharts.com is a great free site though and I would encourage you to check it out.  Please leave me a comment, if you are  experiencing excessive load times so I can make adjustments.  Thanks.

Oh yeah those new rules . . .

The SEC enacted new short selling rules the other day.  Here is a brief and amusing Q&A on the new regulations that also manages an understandable explanation.
Short Selling

Beware the Buy Write – Part 2

Yesterday, we talked about initiating a buy-write in TPX (Beware - Pt. 1). Our hypothetical position involves being long 100 shares of TPX at $27.42 and short 1 Mar 27.5 call at $1.05. Remember that this is hypothetical, in most cases, selling a single call against your long stock position may not be economical because of the combine factors of commissions and size of the bid/ask spread. Using the TPX calls as an example, today's bid/ask, with the stock around $27.02, was $.85-$1.00. To put this in perspective, the one lot that we collected $105 for has a $15 spread or nearly 15% of value. The point is that when you factor in commissions as well, it becomes clear that this is a strategy more suited to a longer horizon rather than for short term trading or a larger size position.

A longer time horizon may be as little as a month and as with any option trade you need time and price action to work in your favor. With a short option position, you want time to move quickly and price to move slowly. Unless TPX were to move dramatically in one direction or the other, due to earnings, some other company specific event, or just macro factors (fyi : TPX has a recent approximate Beta of 2, so one can reasonably expect some movement if the market goes bonkers), each day we expect to theoretically collect a portion of the premium we gained from the call sale.


Ok, in Scenario 1, everything goes exactly as planned and after two weeks the stock hasn't moved around enough to raise concern (Scenario 2) settling in around $27.25 and there is now less than two weeks until March expiration. Time to make some position management decisions. If you own TPX as a core holding, this is a good time to roll the position. Holding implied volatility constant the value of the March call would be around $.50 and the Apr 27.5 Cs would trade around $1.25. In all likelihood, since the stock hasn't moved that much over these past two hypothetical weeks, implied volatility and prices of both options would be lower.


On the other hand if you initiated the trade for the shorter term, you may want to hold the position hoping the stock rises through the strike and your hundred shares gets called away. Or you could take your profits, making $.65 on your call and losing $.17 on your stock, for a net gain of $.48.


Tomorrow, I'll talk about Scenario 2, when things don't go exactly as planned.



Disclosures: The author has no position in TPX or its options.

'Nuff Said . . .

Beware the Buy Write - Part 1

Today I want to talk about the Buy-Write or Covered Call strategy. It is probably the most common strategy employed by both institutional and retail investors and yet there is still some significant misunderstanding of the reasons to employ it, how to manage it (yes, it does require some management), and most importantly what to expect. 

First let's look at the position itself: Long 100 share of stock and short 1 call. The seasoned option trader also knows this as a synthetic put, because the expiration payoff functions are identical. Most investors cringe at the thought of selling a put because of the downside risk, yet they sell calls against their long stock position because they think that they are protecting their downside. It is true that the point at which their long stock position begins to lose money is lower than if they owned only the stock, but the majority of their risk is still to the down side. 

In recent trading Tempur-Pedic (TPX) was offered at $27.42 and the Mar 27.5 call was bid $1.05 (note that at the same time the Mar 27.5 put was bid $1.15). You can see in the graph that the break even for the buy-write and the short put of the same strike are indistinguishable (technically the put break even is $.02 lower than the b-w, but the point is evident. Sadly, market commentators frequently characterize this strategy as neutral to bearish, however down is clearly not direction that someone who has enacted this strategy wants the stock to go. Ideally TPX would stay right around $27.50 and you would kick back and enjoy collecting the premium as March expiration nears. No one expects that, otherwise the option would have been worthless since zero volatility would mean that the options would have no value. So the question becomes: What do you do when the stock does move? And I will cover that in the next post.



Disclosures:  The author has no position in TPX or any of its options.

Hello

Welcome to "I'll give you an option . . .".  This blog as noted in its description will examine option centric trading strategies, both in an academic and practical sense.  Once per week I will post a discussion of a particular strategy, examining both the risk and the reward as well as managing the position.  Unfortunately, the material has the potential to be a tad dry over time.  So while I hope to provide some options education and talking points, I will also be posting random topics of interest and amusement (see Monday's post below).  On the more serious note I have also included a page where you can view an article discussing the impact of a covered call strategy that I authored late last year.  Most of my posts will not be that technical so don't become overwhelmed.  Hope to see you back again soon!