Let's Talk About Buy-Writes: Introduction
WHAT IS A BUY-WRITE?
The term buy-write is completely foreign to most retail investors. In fact, more than a few professional traders scratch their heads whenever they hear this strange piece of options jargon. If you look up the word buy-write in a modern options glossary or educational program, chances are that you wonít find it. Thatís because the term itself is a throwback to the dawn of the options markets. Those were the good old days when options were considered new products and options traders used an entirely different set of jargon than they use today.
However, when you actually examine the term buy-write, its meaning quickly becomes clear. A buy-write is simply a strategy that involves buying the underlying stock or index and writing (a.k.a. selling), a call against it. This strategy probably sounds familiar to you, as it should. Most options users today refer to this as a covered call, and it is one of the most popular options strategies ever devised.
Aside from their archaic name, why should you be interested in buy-writes? I wonít go into the numerous benefits of selling calls against equity positions in this article. Most of you are already familiar with the income generation and portfolio protection offered by this strategy. However, despite these benefits, there has always been a significant downside associated with selling covered calls. This downside has prevented buy-writes from being adopted by significant segments of the retail and institutional market.
The problem is that executing a buy-write strategy, particularly on a large portfolio, is a complex and time-intensive prospect. First, you have to determine which calls to sell against your portfolio. Then you have to calculate the exact number of calls that you need to sell to obtain your desired rate of return.
Finally, if your strategy doesnít pay off in the time allotted, or if you would like to continue your strategy for a longer time period, then youíll need to roll your calls forward and repeat the entire process again. Each of these steps can be extremely cumbersome, especially for an options newcomer. Busy retail customers, fund managers and financial advisers simply don't have the time to go through these steps every month or two.
A great deal of effort has been expended in recent years to overcome this hurdle. After all, if the process of calculating and writing calls against equity positions could be automated, or at least streamlined, then it would go a long way toward expanding the adoption of this strategy among busy professionals.
The ultimate goal of this effort is to create a single product that replicates the returns of a covered call strategy but eliminates all of the grunt work. Unfortunately, the large number of variables involved in the buy-write process makes it extremely difficult to replicate accurately.
INCOME VS. CAPITAL APPRECIATION
For example, how do you balance the desire for capital appreciation with the need to generate income? If you choose to incorporate at-the-money calls into your buy-write strategy, then you will generate significant amounts of income but also eliminate any possibility for capital appreciation.
Alternately, you could attempt to maximize your potential for capital appreciation by selling far out-of-the-money calls. However, the paltry amount of income generated from selling these calls would make the strategy essentially worthless.
Experienced sellers of covered calls usually opt for a middle ground that provides income but also allows for a modest amount of capital appreciation. Unfortunately, an automated technique that allows customers to find that elusive middle ground has yet to materialize.
LONG-TERM VS. SHORT-TERM
Time also becomes a factor when designing any buy-write strategy or product. Experienced traders looking to maximize their returns usually sell front-month calls against their portfolios. This allows them to collect a significant amount of time decay in a short period of time. Unfortunately, the short-term nature of this approach means that the entire process has to be repeated after every expiration cycle. The time-consuming nature of this approach puts it out of reach for many busy financial professionals and retail customers.
Those traders who donít want to deal with that hassle, and who donít mind tying up their capital for longer periods of time, can opt to sell calls with more distant expiration dates. LEAPS (Long-term Equity Anticipation Securities) are very popular tools for this approach. Traders can write LEAPS with expiration dates as far out as several years from the current trading month, providing a great deal of flexibility in how they structure their buy-writes.
The advantage of the long-term buy-write approach is that it allows traders much more freedom, and is much less labor-intensive, than the short-term approach. Traders can simply execute the strategy and then not think about it again for months or even years. The downside to this approach is that it does not provide the amount of income that can usually be obtained by writing front month calls and then rolling your positions every month. However, for many busy options users, it is a worthwhile trade-off.
To Be Continued in Part 1: Automation, Buy-Writes & the S&P 500...
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