A strategy of buying stock and forward selling is called covered writing or a Buy and Write strategy. A call is a contract that entitles the buyer to purchase from the seller a fixed number of shares at a fixed price up until the expiry date. A covered call writer therefore only sells a number of calls equal to the number of shares already owned. The underlying share price of a stock would have to rise substantially to outperform the covered writer. A few basic points on the Buy and Write
- The major risk in a Buy and Write strategy is the price paid for the stock. Investors should only buy stock at a price that represents fundamental value.
- Equally the investor must be prepared to sell stock at the strike price of the option should the share price rise.
- The Buy and Write strategy is used primarily by investors who are interested in generating income. Private investors often have unrealistic expectations for share price growth and underestimate the inherent risk and cost of buying and holding physical shares. A growth stock that does not have a high dividend may trade in a tight range for a period of time. This would mean that the investor would not receive sufficient return to compensate for the holding costs. A strategy of combining a physical stock purchase with writing calls can provide the investors with a minimum return for a given period at an acceptable level.
Once a share price moves up, there are several different actions the investor can take.
- Liquidate the position by selling the underlying shares and repurchasing the call option sold. This is usually only considered where the delta on an option is close to one.
- Roll up to a higher strike price. This is done by repurchasing the option sold and recording a loss, but then selling a higher strike price to record a greater net gain should the share price continue to gain.
- Create a spread by purchasing a higher strike price than the strike price already sold. This would create a bear call spread. The underlying stock could then be sold out.
- Do nothing and allow the estimated returns form the buy and write to stand.
Here is an example of a buy write strategy showing the difference in capital only and also Margin Lending.
| Lihir Gold LGL 12th December 2008 – 76 days until February expiry | ||||||
| Capital only | ||||||
| Buy/Sell | Stock | Units | Price | Total | ||
| Buy | LGL | 4000 | $2.46 | ($9,840.00) | ||
| Sell | LGL Feb 250 | 4 | $0.30 | $1,200.00 | ||
| Calls | ||||||
| ($8,640.00) | ||||||
| Downside protected to $2.16 | ||||||
| Standstill return 12.19% | Annualised 58.56% | |||||
| Exercise at expiry return 13.82% | Annualised 66.37% | |||||
| Using Margin Lending with an borrowing interest rate of 9% p.a. and a Loan to Value Ratio (LVR) of 60% | ||||||
| Buy/Sell | Stock | Units | Price | Total | ||
| Buy | LGL | 4000 | $2.46 | ($9,840.00) | ||
| Sell | LGL Feb 250 | 4 | $0.03 | $1,200.00 | ||
| Calls | ||||||
| ($8,640.00) | ||||||
| Initial capital required per share – $0.984 | Total initial capital – $3,936 | ||||||
| $0.984 | ||||||
| Total Interest cost for 76 days @ 9% – $110.64 | ||||||
| Downside protected to $2.16 | ||||||
|
||||||
|
||||||
| 31.74% | ||||||
If you are interested in learning more about these strategies please contact Tom Boland by email.
