Buy-Write Options Positions – Calculating Breakeven   Leave a comment

To calculate the lower breakeven on a buy-write, you deduct the amount received for calls you write (the “premium”) from the cost of the shares. At expiration, you will get to keep the option premiums you received (by obligating yourself to the call buyer when you wrote the call option contracts). If the stock price is higher than the strike price of the option at expiration, you will also have to sell your stock to the call buyer. This is called “assignment”, and it means that the long option holder is forcing you to sell your stock to them at the strike price of the contract. Regardless of what the stock price is, you have to sell your stock at the previously-agreed upon strike price.

The breakeven number that you come up with is only accurate upon the option contracts’ expiration. Before then, variation in the price of the stock, along with other factors, will cause the day-to-day breakeven to change.

For this example scenario, let’s say you want to buy XYZ corp, which is trading at $50/share on May 1. You expect the stock to stay around $50, but it might go down to $45. You don’t expect the stock to rise much about $55 and you don’t expect it to go much below $45.

In this scenario, a good buy-write position will “protect you” (reduce your cost per share) to $45 or lower. Since you’re paying $50/share, you must get at least $5 in short call options premiums to reduce your cost to $45.

While looking at the June option chain on XYZ, you see calls listed at $55, $50, $45 and $40. Buyers are bidding $3 for the $50 calls and $7.50 for the $45. Since you’re interested in having at least $5 worth of protection, you might choose to sell June $45 calls against the stock you own for $7.50 per contract (the Bid price currently showing in the option chain).

If you sell the calls, you will be obligated to sell your stock to the buyer at $45 at any time between the moment the transaction completes until the option expires on the third Saturday in June. Since you paid $50/share, you’re going to also be selling the stock at a $5 loss. Therefore, in order for your position to wind up being profitable, you must offset that $5 loss with the premiums from the short sale of the covered call options. Fortunately, these calls are paying $7.50 per contract, which leaves you with $2.50/share in potential profits.

The $5 difference between the $50/share cost of the stock and the June option’s $45/share strike price is called the “intrinsic” value of the call. The short call options you sell must always be sold at a price that exceeds their intrinsic value or you are unwittingly obligating yourself to lose money. As an example, consider the scenario above, but instead of $45 calls, you sell $40 calls for $9. In that scenario, you would lose $1/share if you were assigned.

Varying on the above scenario again, you could have sold the $50 call for $3 and had a potential profit of $3 (50-3 = 47, assignment at a max of $50 = $3 profit), but you would not have gotten as much protection, with a expiration breakeven cost of $47.


Posted May 9, 2010 by jeffkeith in buy-write, Investing, Options

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