Q&A
Explore Your Options
Got a question about options? Tom Gentile is the chief options strategist at Optionetics (www.optionetics.com), an education and publishing firm dedicated to teaching investors how to minimize their risk while maximizing profits using options. To submit a question, post it on the Stocks & Commodities website Message-Boards.. Answers will be posted there, and selected questions will appear in future issues of S&C.
Buy-Writes?
A report in Barron’s said now was a good time for “buy-writes” and said the trade was buying stock and selling calls. This sounds like covered calls. Is there a difference and, if not, do you think it is a good time?
You are correct, the buy-write and the covered call are the same strategy. “Buy-write” refers to the fact that the trade involves buying shares and writing calls. “Covered call” simply means that you are short a call, but that position is covered with long stock. An “uncovered call” is a short or “naked” call with no corresponding hedge.
The buy-write or covered call is normally used in a bullish market when the strategist expects a higher price. To create the position, the strategist sells one call for every 100 shares. In most cases, buy-writes are created using out-of-the-money calls, or those with a strike price higher than the existing stock price. It doesn’t matter if the shares are already owned or if the position is new. The idea is to generate income from selling calls while also gathering capital appreciation from the shares. Unlike simply holding shares, the upside is limited by the short calls because at a certain point, the stock will get assigned if it is above the strike price of the call.
Some investors believe that now is a good time to use buy-writes because volatility has been very high and as a result, option premiums on many stocks are very rich. Higher volatility tends to pump up premiums (which has been discussed in this column in issues past). In short, when premiums are high, it is a good time to be a seller. Most covered call strategies are bullish trades, and therefore, the strategy makes sense only if an investor believes that shares are worth holding for the long term.
Let’s consider a simple example using a popular stock. Currently, Apple (Aapl) is trading around about $95 per share, down more than 50% on the year. Some investors might view the recent decline as an opportunity to take a long position in the stock. Yet, some risks to the downside still remain because the equity market remains volatile.
So, rather than simply buying shares, an investor might enter a buy-write by purchasing 100 shares and selling a July 125 call for $10. Since shares cost $95, the income from the calls lowers the cost basis of owning Aapl to $85, or 10.50%. This way, the short call offers a buffer or partial hedge if the stock continues to fall.
What if shares move higher? So long as the stock remains below $125, assignment on the call isn’t a factor. At $125 or more, the call is likely to be assigned, especially as expiration approaches. Assignment is assured if the stock is above the strike price at expiration. Shares would be called away at $125, or 47% above the $85 per share paid to enter the position. For bullish traders, the buy-write makes sense when volatility is high because it offers a partial hedge and ample room for upside profits.
offsetting a position
I have a question about offsetting an option position. When I offset the call/put option that I bought to exit a trade, I have to sell the option with the same strike price and the same expiration date. Does that mean I bear the obligation, not the right, when I sell the option in this case? If not, can you tell me how offset works?
“Offsetting” simply means that you are closing out an existing position. Once you offset, you have no further position in that contract. If, for example, you have entered a buy-write on Apple (Aapl) by owning shares and selling July 125 calls (to open), you offset the position by selling your shares and buying back the July 125 calls (to close). Once the position is closed, there is nothing left to do but look for the next trade.
Avoiding Assignment
I sold calls against a stock in my portfolio. The call options had strike prices higher than the stock price. To my surprise, the stock moved much higher in price and now the strike price of the call option is below the stock price. If I don’t do anything, the call will be exercised and I will be asked to sell the stock. Is there a way to avoid this?
This sounds like a good problem to have because the stock moved beyond your expectations. Your calls are in-the-money and, if exercised, you have a nice profit on the shares. If you don’t want the stock called away, you’ll want to close out the position before expiration or run the risk of assignment. Once you receive the assignment notice, it will be too late to reverse it. You will be forced to honor it by selling shares.
You offset the short call by buying it back. At that time, you will have a loss on the short call, but a paper profit on the shares. This could prove frustrating if the stock falls back, so be careful. Alternatively, you might consider closing out the in-the-money call options and selling calls with a higher strike and or more time left until expiration to avoid assignment.
Income Strategies
I have only just started trading straddles, but I have heard that options can be used as a good regular monthly income. Is this true? If so, what is the name of that particular strategy?
A number of different option strategies can be used to generate income. Almost all of them are designed to take advantage of the fact that options are “wasting asset” — that is, puts and calls suffer from time decay. They lose value over time and some option strategies capitalize on this fact. Most of these strategies involve selling options, which can be risky. If the position is “covered,” that risk can be hedged.
One example is a covered call: a strategy where the investor sells calls against stock. If, for instance, your portfolio includes Aapl trading for $95 per share, you can generate income into that portfolio by writing calls.
Covered calls are by no means the only way to generate income with options. The calendar spread is another example. In the calendar or “time spread,” the investor buys long-term options and sells short-term contracts. Time decay is nonlinear and affects short-term options more than longer-term ones. If investors think Aapl shares will move toward $120 by January 2010, they might enter a calendar spread by purchasing the January 2010 call with the 110 strike and selling the January 2009 call with the 110 strike. If the January 2009 expires worthless, they can sell the March 2009 call with the 110 strike. As long as the stock remains below $110, the strategist can sell the shorter-term options against the longer-term ones.
A variation on the calendar is the diagonal spread. In this case, rather than buying a longer-term option and selling a short-term option with the same strike prices, the trade is created with two options with different strike prices. In the previous example, the strategist might buy the Aapl January 2010 call with the 125 strike and sell the March 2009 call with the $110 strike. With Aapl at $95 per share, the trade will work well if the stock begins a move toward $110, but not beyond, by March option expiration. As long as the stock stays below the strike price of the short call, the option will expire worthless. At that point, the investor is left holding the January 2010 call with the 125 strike and they might then sell the June 115 or June 120 call.
With strategies like the covered call, the calendar, and the diagonal spread, the ideal situation is rangebound trading. In the Aapl examples, the strategist is creating spreads with out-of-the-money calls (strike prices above the stock price), and therefore, the ideal scenario is for a gradual move higher. An aggressive move to the upside will push the stock price through the strike of the short call and then assignment becomes an issue.
If assigned on the short-side of the spread, which is likely if the calls are in-the-money near expiration, then the strategist will probably want to handle the assignment by delivering shares rather than exercising their longer-term option. Why? Because the longer-term contract will have time value remaining, which will be lost if the option is exercised. In short (no pun intended), when selling options to generate income, it is essential that the strategist understands and anticipates the risk of assignment. Know how to handle assignment if it happens.