The buy-write has historically been a popular strategy for investors looking to generate extra income from their stock holdings. Essentially, the investor buys a stock they like, then sells (or "writes") a fairly short-dated call on the stock. Typically, the call is slightly out of the money. The theory is that as long as the buy-writer is comfortable with the underlying stock, nothing bad can happen. Either the stock goes above the strike price when the option expires and is called away, resulting in a nice short-term profit and an outstanding annualized rate of return, or the option premium is pocketed, effectively lowering the cost basis on the stock.
For example, let's say shares of XYZ stock are purchased at 38 and an XYZ 40-strike call, expiring in 2 months, is simultaneously sold. A premium of $2 per contract is collected for the call, lowering the net cost of the stock holding to 36. If XYZ closes above 40 when the call expires, the stock is called away and the investor receives $40, for a profit of $4 on a $36, 2-month investment. This, an 11.1% return on capital in 2 months, is the best-case scenario. If an investor successfully executes a buy-write strategy every 2 months, it would result in annual profits of 67% without considering the benefits of compounding profits.
Of course, the more likely scenario is that the stock will be roughly unchanged from its purchased point when the short-dated option expires, in which case the investor would show a profit, albeit a much smaller one. For instance, if the stock did not move at all during the subsequent 2 months, the option would expire worthless and the stock effectively generated a better-than-5% dividend for the period ($2 divided by the original share price of $38). Annualize this, even without compounding, and annual profits are around 30% if the strategy is used once every 2 months.
Losses wouldn't begin to stack up on the position until the shares drop below 36, where the $2 decline in the stock price is fully offset by the pocketed option premium. The buy-write player is subject to much greater potential losses than profits, since he is fully exposed to the stock's downside while the profit is capped at $4 no matter how much XYZ rallies. Of course, this is the same kind of downside exposure assumed when a stock is purchased.
Let's say the idea of generating income by putting stock positions to work is intriguing, but the notion of sacrificing a potentially big winner is not (nor is the thought that potential losses are larger than maximum profits). Is there a way to generate income and keep the upside potential?
Actually, there is, and we call it Schaeffer's "Buy-Write Plus." The strategy involves using a portion of the premium taken in from selling a call to buy another call with a higher strike price. The call you buy allows full participation in a major upward move, so there are no worries about letting a really big winner get away.
In the earlier example, instead of just selling the 40-strike call against an already purchased stock position, the "Buy-Write Plus" strategist would also buy a 45 call, which is farther out of the money. A trade in which more expensive option is sold and a cheaper one – with the same expiration date – is purchased is known as a credit spread. Selling a credit spread against a stock position, in a sense, offers the best of both worlds. It lets the stock generate income while retaining the chance for significant upside participation, should the stock make a big move.
The price of keeping some upside, of course, is a lower return than the standard buy-write if the stock remains flat or trades slightly higher during the options' life. To continue with the above example, let's say you buy the 45-strike call for $0.50 (per contract). The net premium collected is now only $1.50 (before commissions). If the stock ends up between 40 and 45 at expiration, it will be called away thanks to the sold 40 call. When everything is netted up, $40 is collected on an investment of $36.50, which is still a 9.6%, 2-month return that annualizes to more than 57% with no compounding. If the stock doesn't move, the effective "dividend" from the net call premium is around 4% ($1.5 divided by $38), which annualizes to 24% without compounding. And the downside protection extends to 36.50 rather than 36.
Saving the best for last, if the stock explodes, this investor will participate in all upside on a point-for-point basis at any price above 45, the strike of the purchased call. If the stock moves to 48, for example, the stock position would be called away at 40, but the 45 call is worth 3. A total of 43 is banked on a 36.50 investment, translating to 17.8% over 2 months, which annualizes to well over 100% without compounding. Plus, upside is unlimited, unlike the straight buy-write.
Let's look at the example of the stock rising to 48 in a slightly different way. The underlying stock position gets called away at 40 by virtue of being short the 40-strike call. But ownership of the 45-strike call provides the ability to call away someone else's stock at 45. Thus, 3 extras points (48-45) are captured that would not otherwise have been possible, if just a 40 call had been shorted against the stock. The ability to pick up big incremental gains like this is worth a bit of premium - in this example, the 0.50 given up by selling a call spread rather than just doing a traditional buy-write. Every individual investor has to decide if the upside potential beyond the purchased strike is worth the decreased income at the outset of the trade.
The table below shows the returns at expiration over a range of stock prices for the 2 strategies:
Buy-Write Plus Strategy Pros and Cons:
Pros:
- Allows stocks to work in the investor's favor by generating option income
- Significantly better upside potential than standard buy-write
- Should enhance overall returns under most market conditions
Cons:
Lower stand-still returns than traditional buy-write
Additional commissions
Lower income generation means less protection against prolonged downtrend by the stock (i.e., higher cost basis)
