Wednesday, February 24, 2010

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.

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