Beware the Buy-Write – Part 4

Alright, this post should wrap up our discussion on the buy-write. We have taken a look at some of the considerations that should be made when the position performs optimally (the stock goes nowhere) and if the stock drops more than expected. Now what happens when the stock moves unexpectedly higher?

Remember that in break even analysis the buy-write has the same payoff function as a short put, therefore in an up move profits are capped at the strike price – stock purchase price + plus premium received. The hypothetical position was established by buying TPX at $27.42 and selling the Mar 27.5 call at $1.05 yielding a maximum profit of $1.13 for any price over $27.50 at March expiration. In a mild or severe downturn in TPX, it is likely that you will be able to collect most or all of the premium from the call and take a loss on the stock. One can think of this as a reduction in the basis price. In other words, if the stock does not get called away and you have pocketed the entire premium the net cost of the stock is now $26.37 ($27.42 - $1.05). While your accountant or the IRS may not see it exactly like this, it helps in understanding the impact of a rising stock.


At this point, after the hypothetical two weeks have passed, TPX is trading at $29.50 and there is just about a week left to expiration. Keeping implied volatility constant over the time, the calls are now theoretically worth $2.07 and the puts are worth $.07. Decision time. It seems highly likely that the calls are going to finish in the money, probably by more than you collected for the calls, so what are the choices? First, you could hold the position to expiration and allow the stock to get called away, pocket your 4% return and move on. You could do the same thing by closing out both sides of the trade prior to expiration. But what if you want or need to hold the stock position for a longer period than two weeks?


This is the tricky case because, and this is the important point, if you buy the call back you have raised your effective price whether you close out the calls and continue to hold the stock or you choose to roll the call out on the calendar. Let's say you are able to sell the Mar 27.5 call for $2.05 to keep things simple. You now have a basis of $28.42 ($27.42 + ($2.05 - $1.05)). This is fine if the stock continues higher and you keep rolling to higher strikes, but if and when the stock pulls back, the position will start losing money sooner. In other words, the profit from the synthetic short put can only be fully captured by closing both sides of the position. This is not to say that simply closing the call side of the transaction isn't the right thing to do (again that evaluation can only be made in light of your expectations for the stock), but the impact must be taken into consideration when managing a portfolio. A final note on this position, if the overall portfolio strategy is to continue to employ the buy-write, it may be worth considering an early roll (before the rising price eats up all of your premium) if you feel that the stock is likely to continue to appreciate. This can help mitigate the impact on your effective price.


Ok let's sum it up:

1. Stock behaves optimally and doesn't move much. Pocket your premium, smile and do it again.
   
2. Stock drops below your break even. If it is a long term position and the reasons you got into the stock (fundamentally or technically speaking) haven't changed, consider writing the next month out and receive some consolation in a lowered effective price.
   
3. Stock soars above the short strike. Again depending on your outlook, you may want to roll the calls out or close the position down, but be aware that you have increased your basis and may start suffering losses more quickly on a pull back.
   

The purpose of this discussion was not to endorse or discourage the use of the covered call strategy, but to clarify its impact in different circumstances.


I'll be back with another strategy later this week.