Buy/Write - A Covered Call Option Strategy

Reasons for Writing Covered Calls or a BUY/WRITE

I will attempt to explain the reasons why Writing Covered Calls is essential in maintaining a more wholesome investment strategy

For a start, any and all investment strategies must achieve 2 main objectives; namely a primary objective to Profit and a secondary objective to Conserve Capital Invested. Hence, when we open an equity position, our aim is to close off that position with a predetermined profit or loss.

Writing Covered Calls can achieve these 2 specific objectives.

The simplest explanation of a Write Call option, is the act of SELLING a Call Option at a specific Strike Price and at a specific month.

Since most of us are more accustomed to LONG positions, the chosen example shall be LONG stock and Write Call option. This is classically known as Buy/Write position.

Let's use Citibank as an example. See what C is trading currently and the Option Chains(the choices of Calls and Puts) available.

Supposing you decide to LONG 100 shares of Citibank and Write a Sep08 20 Call. Fyi, 1 contract of option = 100 shares of stock.

You would be Buying 100 shares of C at $18.54 and SELL 1 Contracts of Sep08 20 Call. You would have paid $1854 for the 100 shares of C and receive into your account $85. Your net outlay for this Buy/Write position is $1769.

When you establish this Buy/Write position, you have effectively enforced 2 very important principals of trading.
#1) You have predetermined your selling price. In this case, you have decided the target price of $20 as your selling price
#2) You have also predetermined a margin of error, which the risk of this trade

Let me explain further by citing 4 scenarios that can happen once you enter this Buy/Write position.

Scenario #1 - Citi Rallies Mildly
By the 3rd Fri of Sept. If the price of 18.54 < 1769 =" 4.8%" style="font-weight: bold;">47.4% when annualised. In other words, if you do this month after month, theoretically, you would have made a handsome 47.4% on your investment. Not bad.
More importantly, your primary profit objective is achieved

Scenario #2 - Citi Remains Roughly Unchanged
By some stroke of chance, C remains roughly at 18.50 region by 3rd Fri of Sept.
All of Scenario #1 applies; ie. you still obtain 47.4% of annualized return on your investment

Scenario #3 - Citi Price Falls
Any astute and long term stock player will know that taking a loss is part of the game. But the question is when to take a loss. Setting too tight a stop loss can result in unnecessary wastage of commissions paid and not allowing sufficient price whipsawing effect. Yet, setting too large a stop loss can result in depletion of investment capital. So, where is a good balance?
Using Buy/Write strategy, you allow yourself to absorb up to ~$85 of paper losses, without actually incurring a real loss. How so?
Remember, you paid $17.69 for shares of Citibank at a price trading at $18.54. Effectively, you have given yourself acceptable paper loss of $0.85 downswing on C before a REAL loss is incurred. Therefore, if C price drops to $17.69, and you sell off your LONG C stock at this price, you would have accepted a loss of $0.85, or did you? In reality, you did not. This is because you have been credited $0.85 at the moment you WRITE Sep 20Call and received $0.85 credit. Although you would have suffered a loss from selling C at a lower price, you have already gained from Writing a Covered Call option. This results in a net neutral balance in your account (less any commissions). It provides you with a safety margin.
This is a disciplined way of ensuring your 2nd objective of Conservation of Capital is achieved.

Scenario #4 - C Rallies Past $20
What if by 3rd Fri of Sept, C price trades past $20.
This is wonderful ! It is a happy problem.
What will happen is that you will be assigned on your WRITE Sep 20Call. What this means, is that you will be obligated to deliver 100 shares of C to someone. This is done via selling your LONG 100 Shares of C at $20. Is this a problem? Absolutely NOT.
Remember that your original "purchase" price of C was at $17.69. If indeed C price zooms past $20, you would have profited handsomely.
Your return (known as "if-called" return) is calculated as
2.31 / 17.69 = 13% or 129% annualized... this is a bagger !

Happy trading everyone...and I wish you HUat HUat !!!!