Real Buy-Write Examples   Leave a comment


So now that you’ve seen how to calculate your breakeven and your potential max profit, let me show you some examples and talk about some of the scenarios you would want to anticipate.

First, let’s reiterate a couple points –

  • When I talk about a “Buy-Write Position”, I am describing a set of transactions that consist of the purchase of stock in even 100-share lots and the sale of an equivalent number of covered call option contracts. You sell one option contract for each 100 shares of stock you own. I’ll refer to the sale of the calls as the “write”.
  • My primary criteria for a trade are based on:
    • My expectations of what the stock might do in the period of time I want to “write” it for – usually the next month but sometimes I’ll write it two months out.
    • My desire to make at least a certain minimum percentage profit if the stock remains unchanged
    • My desire to avoid foreseeable losses by selling off some of the value of the stock in return for time premium. In other words, having every trade result in a win.

Research In Motion (RIMM)

On 4/21 I noticed that RIMM closed just below it’s 50-day moving average and it looked like it was going to bounce back to trade in it’s higher March range around 74-75.

Knowing that I’m frequently, if not always, wrong about these bullish feelings, I also looked at what the reasonable potential downside the stock might have. Clearly, the April 5 low stood out at around $67 and coincided with the highs on 1/14 and 1/15. From this, I established that I would want protection to about the $67 level.

Here’s a six month chart of RIMM as of today. Click the chart to see it full size

With that criteria established, I looked at the option chain for a call that would get me to that level of protection. So, looking at options that had an intrinsic value of around $4.60 (the 4/1 close price of $71.60 minus the $67-level protection I was looking for).

Unfortunately, in order to really make that work, the option chain would have to have an option for every dollar increment in the stock’s price. The RIMM option chain trades in $5 increments at this level. So I had a choice between a $70 and a $65 call.

The $70 call closed at $3.20, and the $65 call closed at $7.10.

Writing the May $70 would put my protection level to $68.40 (The stock price of $71.60 minus the May $70 call premium of $3.20 = $68.40). This was a bit higher than my initial protection target at $67.

Writing the May $65 would put my protection level to $64.50 (The stock price of $71.60 minus the May $65 call premium of $7.10 = $64.50). This was better in terms of protection.

In terms of potential profit, the $70 write would yield $1.60 or 2.34% if assigned, whereas the $65 write would yield $0.50 or 0.78%. These calculations were all just a quick spreadsheet job and did not include brokerage fees.

Here’s where judgement and risk taking come in. My expectation was that the stock would return to trade in the $74-$75 range, and I expected it to trend toward the upward-moving 50-day average. In addition, I noticed that the Chande Momentum Oscillator (the blue line below the stock plot in the chart above) was moving up. With this in mind, I decided to go with the May $70 write and try to capture a larger profit with a little less protection.

On 4/22, RIMM opened a little lower. I modified my spreadsheets and put in my multi-leg order for a buy-write on RIMM that executed something like this:

  • Buy 300 shares of RIMM at $71.31/share
  • Sell 3 May $70 calls for $3.23/contract

If you’ve been watching the market over the last week or so (or turned the news on lately), you’ve seen how the market took a big dive. Since I still had some level of confidence in the market, I left the position on.

Had I just bought RIMM stock and held it through today’s close, I would be down $1,044 or 4.88%. This would have exceeded my stop-loss and I would have simply lost money on the position. This is a profit/loss chart of a straight long-stock position of the 300 shares of RIMM I bought without the offsetting options. Click the chart to see it full size.

Long 300 shares of RIMM by itself

Because of the time left on the options and the increase in the stock’s volatility due to the recent market turmoil, the position is down about 1.8% or $371.46. Here is a chart showing my current position, as of the close today. Click the chart to see the full-size version.

Buy-Write of RIMM, today's value

At expiration, if RIMM remains unchanged (RIMM closed at $67.83 today) I would be down about $93 or 0.45%. You should be noticing the difference in the today chart above, and the expiration chart below – this is how you leverage the time and volatility value in options to offset risk.

Buy-Write of RIMM at expiration

The bad thing about this position is that it has not yet met one of my primary objectives – which is to not lose money. Fortunately, I’ve been able to offset a great deal of the market’s dive with the premiums I received for the calls. You can see, however, that the stock did dip into some seriously negative territory, even with the options premiums received.

Assuming the bottom doesn’t drop out of the market (again lol), we’ll see what happens at expiration on May 22nd.

The next post will talk about some of the potential scenarios that might occur and how I might either adjust or extend the trade to attempt to fix the position and move it back into the green.

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Posted May 11, 2010 by jeffkeith in buy-write, derivatives, Investing, Options

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