Thursday, February 25, 2010
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.