Buy-Write Option Strategy Generating Nice Profits

by: David Enke December 01, 2008    

David Enke

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The option strategy of buying stock and then writing call options against it - known as buy-write - is still generating some of its highest premiums in over 20 years (see WSJ article). By using a hypothetical version of the strategy using the BMX index as a comparison, the CBOE found that a buy-write strategy would have produced an 8.1 percent gross monthly premium in November, topping the second highest recent premium of 7.1 percent generated in October just a month earlier. Since June 30, 1986 until the end of October, 2008, the strategy has generated an average annualized return of 9.2 percent, while the S&P 500 index produced a return of 8.7 percent over the same time period. While volatility will not always be as high as it is now, nor will it always generate healthy option premiums and a nice return over the S&P 500, even an average 0.5 percent extra return over more than 20 years starts to look pretty good - not to mention compounds into some significant cash.

For those a little intimidated by option strategies, keep in mind that with a buy-write strategy your obligation for the written call is covered by owning the stock (a covered call). Therefore, you don't have the same potential "infinite" loss that scares away many investors from writing options. Of course, there are downsides. Besides the fact that your long position could decrease in value, an additional downside is that your long stock position could be called away if the stock produces a significant move - causing you to potentially leave some money on the table. Nonetheless, the strategy forces a sell discipline, which for many is the most difficult part of investing. For instance, if a 3-month call has an exercise price that is 20 precent away from the current price of the long stock position, then the stock could be called away once its price rises more than 20 percent in 3 months. Certainly disappointing when the stock moves much more than 20 percent, but you still lock into 20 percent (plus the premium) in 3 months or less. Not bad in my book. In the mean time, the premium provides additional downside protection, just in case you end up not picking a winner. For those interested, some additional information on buy-write strategies can be found here, here, and here.

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This article has 6 comments:

  •  
    Dec 01 01:54 PM
    The headline writer takes the privilege of being wrong - BUY-RIGHT vs the author's correct, BUY WRITE.

    Headlines, almost always, are written by the platform publishing the article. Newspaper, magazine, internet column.

    The final editor needs to hire a ploof reader. LOL
    Reply | Link to Comment
  •  
    Dec 01 04:12 PM
    Thanks for the heads up. The headline has been corrected.
    Reply | Link to Comment
  •  
    Dec 01 05:45 PM
    PBP is an ETF that implements buy-write on the S&P 500, and seems like a good alternative to SPY.
    Reply | Link to Comment
  •  
    Dec 01 09:08 PM
    There is also BWV, the ETN version of the Buy Write. Along with this there is the closed end funds, but they have much higher expense ratios.

    CEFs: BEO, MCN, BEP, ETB, ETV, ETW.

    Normal cautions and due diligence on these folks.

    ~X~
    Reply | Link to Comment
  •  
    Dec 02 09:29 AM
    Many Closed End funds employ a buy-write strategy and are trading at 20%+ discounts and thus 20%+ annual yields!! Many of these ARE sustainable at these levels, i.e. the sell call strategy covers the dividend payment comfortably. My favorites are DPD, DPO which hold only the Dow stocks. DPO is leveraged and thus more volatile. Others are EOI & EOS which sell calls on individual securities and not indexes. Finally, international fund IGD has a huge 23% discount and yields over 20%. All of these are monthly pay, which I like since the NAV & price don't get hit too hard when they go ex-div. 3 CEF's that have a bit more protection because they have maturity dates are BEP, BEO & RCC. BEP matures the earliest in March 2010 so eventually, the discount will go to zero.

    All of these funds have FAR outperformed the DJIA and S&P 500 when you plug the dividends back in and yet trade at huge discounts. Great opportunities!! Oh, and the expense ratios are typically around 1%, similar to a mutual fund.
    Reply | Link to Comment
  •  
    Dec 02 10:37 AM
    "... just in case you end up not picking a winner." This is a key phrase in this article. If you are good at picking winners you won't want to be writing calls for peanuts and having your winners called away. Your portfolio ends up full of losers going down much faster than the call premiums are helping. Then what do you do? Take GE for example. A few months ago you may have bought that juicy dividend stock in the high twenties and wrote some calls. Soon afterward Immelt goes on Mad Money and lies about the company's prospects, then he does a deal with the devil - Warren Buffett. The bad news piles up and you are left with a stock trading at $15-17. What do you do now, write an $18 strike call on your $28 stock? When volatility is high and you got weasels in the chicken coop, this is what can happen. Writing calls on a bunch of seemingly good stocks can never make up for these kinds of losses.
    To sum up, if your record shows that you are a good stockpicker, don't sell calls for small returns (You know this already). If you are not a good stock picker but are intrigued by this technique, buy a fund that specialises in buy-writes and be satisfied with an average return.
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