Your Buy-Write to Profit

A primer on this basic option strategy. Plus, why you shouldn't sweat the volatility index or put/call ratio.
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This article originally ran May 12 at 2:44 p.m. EDT on TheStreet.com

The thought of trading options can be intimidating for a new investor. You often hear people say how risky they are and how much money you can lose. But if you stick to the basics,

options can be a great tool for your portfolio.

In an interview with

TheStreet.com

, Randy Frederick, director of derivatives at CyberTrader, a unit of

Charles Schwab

(SCH)

, discussed some basic strategies and what new option investors should expect.

One of the most simple, yet rewarding trades Frederick recommends is the buy-write, a bullish strategy consisting of buying a stock and writing (i.e., selling) a near-term covered call option to generate income from option premiums and dividends. "A buy-write is a good basic strategy that new and seasoned investors can employ

and add to their repertoire and is the most basic income strategy," he said.

To execute a buy-write you would buy stock in the open market while simultaneously selling calls that are one or two strikes out of the money. A strike is the price at which an asset can be bought (for a call) or sold (for a put) by the option holder. Keep in mind that when you sell option premium, which is the price of the option, time decay (theta) works in your favor. Theta measures the rate of decline in the value of an option due to the passage of time. An option is a wasting asset: All things being constant, an option will lose value as it approaches the maturity of the option. Be sure to sell calls that have at least a month or two left until expiration.

If the stock rises above the strike price, your short calls will be exercised, in which case you still make a profit on the premium you originally collected. If your calls are exercised, then the shares you own will be sold. If the stock declines, the call you sold will expire worthless, and you will keep the full premium.

Always make sure you know your risk/reward before entering into any option trade. Here is the risk/reward for the buy-write trade:

The maximum risk of the trade is the stock price paid minus the call premium.

The maximum reward is the call strike minus the stock price paid plus the call premium.

The break-even for the trade is the stock price paid minus call premium.

Trading equities can be a difficult task in a sideways market. If the market is range-bound, like last summer, a buy-write could be a good way to generate income.

Debunking the Myths

The volume of option trading has exploded over the last two years. Both retail investors and large institutional investors are getting into the mix. Option volume for April was up 18.39% compared to 2004.

Someone who is new to the

option trading game might become overwhelmed with the number of exchanges -- there are currently six -- and

option lingo like put/call and VIX. Try to block these terms out of your mind for now. Neither one holds the weight that they once did in the past.

The put/call ratio measures the ratio of put buying to call-buying. Some use it to gauge investor sentiment. You need to look at the put/call ratio on a moving average or dollar-weighted basis, not daily. A daily put/call ratio can be misleading because many factors can lead to higher put-buying on a given day; one is the puts just might flat out be cheap. This would show a high volume of put buying on low volatility.

"I am more interested in the put/call ratio of open interest," said Frederick. Open interest shows the total number of options or futures contracts that are not closed or delivered for a particular day. Unlike the daily put/call ratio, which measures opened and closed positions for the day, the put/call ratio of open interest can be a better gauge of sentiment because it examines only open contracts.

Extremely large trades, such as delta-neutral spreads, also can move the ratio. A delta-neutral trade is a spread consisting of positions with offsetting positive and negative deltas that bring the overall delta position to zero. A delta is the ratio that compares the change in price of the derivative to the change in price of the underlying asset.

Another trade is if an institutional investor takes a shot and buys 50,000 cheap out-of-the-money calls for 15 cents each. This would have a significant impact on the put/call ratio, but in the end it doesn't really mean a darned thing. He/she was just taking a gamble with the trade.

The CBOE Volatility Index (VIX) represents the implied volatility of the S&P 100 (OEX) option. It is calculated from both calls and puts and is meant to measure forward volatility. The VIX was once a household term for measurement of market risk, but since the introduction of exchange-traded funds (ETFs) and other sophisticated instruments, it has lost much of its luster.

"The VIX has lost a lot of its value and has been trending downward for years now," said Frederick. "The threshold levels that were once in place to gauge market direction have now disappeared. I do not totally discount its relevance, but it does not have the same weight it used to."

The biggest misunderstanding is that people view the VIX as strictly a contrary indicator of the direction of the market. Actually, the VIX is an outdated indicator of market tops and reversals.

According to one CBOE floor market-maker: "It is difficult to use the VIX for market direction because the volatility we have been seeing for some time now is very industry-specific and not across the board. Energy is a perfect example, and now autos."