Friday, February 26, 2010

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.

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