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Buy-Writes and Trade-Offs

Buy-writes are less risky than owning shares because writing calls lowers the cost basis of owning the stock, but if shares really rally, there is limited upside.
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A buy-write or covered call is a Level 1 options strategy. Most brokers will allow customers to initiate the trade, even if the investor has no previous options trading experience. It carries less risk than outright stock ownership. In the trade, the investor is buying shares and selling calls. One call option is sold for every 100 shares. However, while the buy-write is a very basic options strategy, it's not necessarily a no-brainer. There are trade offs to consider when looking at writing in-the-money, at-the-money, and out-of-the-money call options.

Buy-writes are less risky than owning shares because writing calls lowers the cost basis of owning the stock. For example, if I buy 100 shares of Chinese Internet company Baidu.com (BIDU) - Get Baidu, Inc. Sponsored ADR Class A Report at $100 per share, my cost basis and risk is $100 X 100, or $10,000 (excluding commissions.) On the other hand, if BIDU November 100 calls are trading for $8.5 and I initiate a November 100 buy-write, my risk is ($100 - $8.5) X 100 or $9,150. In the buy-write, the risk, cost basis, and the break even are the same. As long as shares hold above $91.50 through the November expiration, I am in a winning trade (excluding commissions.)

Writing calls against shares lowers the cost basis and break even of owning the stock, but there is a trade off. If shares really rally, I have limited upside. For example, if BIDU is above $100.00 through the November expiration, the calls will be assigned and I will sell shares at $100. At that point, the profit is $100.00 - $91.50, or 9.3%. Of course, I can avoid assignment by closing out the call position at any time prior to the expiration. That is, I can buy-to-close the calls in an offsetting trade. Still, if the stock makes a move higher, the calls will appreciate in value and the losses on the short call position will offset gains from the increase in the share price. The bottom line: buy-writes are less risky than owning shares, but there is less upside potential as well.

But not all buy-writes are created equal. The risk-reward can vary depending on whether the strategist is selling out-of-the-money, at-the-money or in-the-money calls. Some investors prefer to sell in-the-money calls. For example, we can initiate a Nov 80 buy-write on Baidu today for $78.00, or $100.00 per share minus $22.00 per call option. $78.00 is now the cost basis and the break even through the November expiration. What's the trade-off? The upside is limited to $80.00, or 2.6%. If shares stay above $80.00 through the November expiration, 100 shares of BIDU will be called for every short November 80 call option.

More aggressive buy-writers like to sell out-of-the-money calls. If I write the BIDU November 120 covered call, for example, the premium collected is $2.50 and the cost basis is $97.50 per share. Now, the upside is to $120.00, or 23.1%. By selling out-of-the-money calls, the strategist is in a higher risk-reward position compared to in-the-money or at-the-money calls. The chart shows the potential risk-reward for BIDU buy-writes at various strike prices. The higher the strike, the greater the risk-reward.

So, not all buy-writes are created equal. Selling deep in-the-money calls against shares is a relatively high probability-low reward strategy. Selling out-of-the-money calls is a higher risk-reward play. In all cases, however, the buy-write is less risky than owning shares because the cost basis is less. The trade off is that the upside is also limited. The investor has sold calls and therefore is making the statement that they are willing to sell the stock through the expiration at the strike price of the call option.

See you Wednesday!

At the time of publication, Fred Ruffy held no positions in the stocks or issues mentioned.

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Frederic Ruffy is an experienced trader and provides daily commentary and analysis of the options market. He is co-founder of the web site, WhatsTrading.com. His work has also appeared in Futures Magazine, Technical Analysis of Stocks & Commodities, Stock Futures and Options, and Sentiment.

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