Buy Write Income Strategy

[Function 10]

Hello everyone,

 

I was curious whether a strategy that I recently concocted would be viable, profitable, and not take unnecessary hidden risk.

 

It goes as follows: Screen for volatile stocks with high volatility premiums in the options. Companies that have volatile stocks (but not excessive risk of permanent loss of capital) make for the best selections i.e. not healthcare stocks with binary events in the near future and not small cap stocks that may be out of business in 6 months time.

 

Strategy: Buy the stock, sell an equivalent number of at the money calls for the shortest dated expiration. Regardless of how the stock and options do at expiry, roll the strategy forward into the next closest expiration date.

 

The strategy works because you collect the premium on the options, month after month. The way the stock moves is pretty irrelevant because the calls are rolled forward to the nearest expiration date with the highest call premium month after month.

 

Trade example: EBAY

Price: 34.25

Option: May 11 Call

Strike: 34

Premium: 1.01

(source: Yahoo! Finance)

Days to expiry: 21

 

Annualized return = (premium collected / amount invested) * (365 / days to expiry)

 

1.01 / (34.25-1.01) * 365 / 21 = 52% annualized

 

Sound like a good return for limited risk -- who cares if eBay tanks 50% you take the premium to make up for it. If it goes up 200% -- well, you missed some upside but the premiums are fantastic.

 

And eBay is not likely going to go under in the next few years

[TheNegotiator 13]

I don't know but I'm pretty sure you would end up losing on price and transaction costs if you look into it properly.

[SIUYA 11]

a few points

1 ) any strategy that caps your upside, and exposes you to all the downside does not make sense to me - my own personal approach to the markets.....

2) the strategy can and does work - there are buy write funds out there....they usually outperform the long only funds.....but they are benchmarked to those funds and hence you pretty much just slightly outperform the long only funds.

3) they also work as they usually have a constant flow of money coming into them, and hence when markets fall they can ride it out and rewrite the options again.

4) the idea that a stock is volatile and less risky does not happen that often in reality.....

5) one or two trades can take you out if you are using excesive leverage - no new news there (this is the old picking up pennies in front of the steamroller analogy)

6) you generally need to adopt a portfolio approach to make this work - its the selling insurance premium approach - it works if the pool of money is big enough, the spread of risks is enough a single event wont be too costly, you require, cash flows to keep you in the game when a natural disaster occurs, etc; etc;

7) as the Neg says - costs can kill you if you get it wrong.

 

Otherwise, like anything it will work some times, a lot of the times, most of the time.....its just when it does not, there will be no liquidity for you, and you will be on the wrong side of the trade.

(i have friends who run a few funds like this - they know how to do it, they make money from running the funds, but even they say its not a great strategy to make money from)

[NOptionsGuru 10]

Well, I would just like to start off this thread by saying that you're on the right track but your logic is slightly off. If I'm understanding you correctly, you're saying, "If ebay tanks 50% who cares..." So you're not concerned with the paper loss that you would take on the stock if it dropped 50%?

 

Lets think about that for a minute. Selling an at the money (ATM) covered call will only give you limited downside protection. So if you buy Ebay at 34.25 and sell a May 34 Call for 1.01 as in your example, your cost basis (CB) for the trade is 33.24. Therefore, so long as ebay stays above 33.24 you are making something. Below that you are losing money.

 

Another thing to think about is this simple fact: volatility = risk. The more volatile the stock is, the more risk is involved. Hence why options premiums for high volatility stocks are much larger.

 

This type of trade works best when the stock and the overall market is in a stagnant to slightly bullish trend. You wouldn't want to implement it during any time of pending news where you are capping your upside potential and not giving yourself all that much downside protection.

 

There's a whole lot more to it than what is written above but I'll leave it at that in order to keep from writing a book. As I would do prior to implementing any new strategy, I offer this piece of advice to you. Paper Trade paper trade paper trade... for a few months and see how it's working out for you, what changes you need to make to "fine tune" the strategy and once you are happy with the results, then take it to the real world of trading.

[Josh7 10]

Re: Buy Write Income Strategy

 

2) the strategy can and does work - there are buy write funds out there....they usually outperform the long only funds.....but they are benchmarked to those funds and hence you pretty much just slightly outperform the long only funds.

 

 

 

I know this may be a bit off topic since it mainly deals with option activity but I observed something unsual in an option chain on BAC. There was over 240,000 call option volume placed in a day on an option with only like 500 open interest. I know some individuals point out that this can indicate "insider trading" but someone posted on a site that it was a few large buy/write transactions with what appeared to be a captured image of the transactions(which was buy/write) from his platform. Do some brokers/platforms offer that ability to review transactions in the market?

[SIUYA 11]

after reading my quote - it was badly written, but in answer to your question....try Interactive brokers. They have a great options platform.

I dont use them but I often hear people quote think or swim as an options platform also.

sounds like you are after a scanner of sorts.

 

when looking at such large transactions, often you need to know if there was another side - ie; was it part of a roll that had been previously done, was it some sort of portfolio program over existing longs, or was it even just a new position - sounds lie a large transaction for a one off, but there are many things it could be - dividend strips, pairs trades, swaps/warrant rehedges, massive punt.

 

To be honest, I think these might alert you to do more digging, but exactly why many of these trades are done, are often not known as you dont see the other side to things.

Do you think these sorts of trades want to be telegraphed to the market....and if they did, why? (food for thought)

[OlmsteadOptions 10]

The buy write trade you describe is also know as the covered call trade. Some investors are not aware that this trade carries exactly the same risk and reward profile as selling a naked put. Strangely, most brokers will allow a covered call trade in a retirement account, because it is a "conservative" trade, but not allow selling a naked put because it is a "high risk" trade. (??!).

 

The problem with the buy write trade (covered call) arises when you reach the expiration date and the stock price is at an inconvenient level. Suppose the stock price is well below where you bought it. Then you sell an at-the-money call for the next cycle, but at the next expiration date the stock price has recovered back to the level you bought it and more. Now (i) you are going to give up your stock for much less than your purchase price, or (ii) you are going to buy back the short call for a big loss and hope that your stock continues to rise. Not a happy choice.

 

Other difficulities arise if the stock price is well above your purchase price after the first cycle that you do the trade, although in this case you can give up the stock for a profit on the trade.