Thursday, May 27, 2010

A Buy-Write investment strategy...

Somebody recently asked me about how to make money when their stocks 'haven't moved' and if they should re-season their portfolio.  One thing I've learned about self management and the free access to the investment world via all of the on-line brokers, is that it can make you impulsive.  Overcome this by educating yourself...off line.  It's easy to get caught up in the herd mentaility and before you know it you've lost MORE money!

Here's the strategy.  A buy-write creates an income stream against a position you hold monthly.  It's rather conservative so you can even do it in your IRA (with authorization --and the only options strategy approved for IRA's).  OOHHHH he said 'options' which are derivatives and they ruined the world...CNN said so!  Not really. 

Okay, how does it work?  In the example above a friend said that his stocks were not going anywhere.  Upon closer look they were channeling or staying in about the same upper and lower ranges.  This kind of predictability creates a 'bet'.  That bet is that the stock may not break out to upper highs or lower lows.  For the sake of simplicity I'll just explain the theory and you can look up the stock options call symbols yourself.  Besides, they recently adopted a new call letter standard and I'm not going to type them because they're too long now.  So concept.

Let's pick a stock, XYZ.  You see it channels and you don't want to sell at a loss but you're in not hurry to sell either.  Okay.  So you can look at options that have a premium and you can sell somebody the right to buy your stock at a higher price at some point in the future.  That's a deal huh?  If XYZ is trading at $10 your cost is $8, would you be willing to sell your stock @ $15 if I paid you?!

Example:  XYZ stock is trading @ $10; The June 15, 15 CALLS are trading at say .30 (there's a lot of theory here and I'm just picking a number for mathmatical purposes but .30 would not be an accurate price for these calls).  CALLS are an option that when sold obligate you to sell your stock at a set price, so you would have to sell your stock @ $15 in this example.  Is that worth it?  $8-$15= $7 profit+.  You would be 'writing' a call.  Hence the name...buy (stock) and write (options).  Calls are priced per 100 shares so you would control effectively 100 shares.  So 100 x .30 (quoted price) = $30 less commissions.  Well that's only  $30 big deal.  Well if you own 1000 shares you can write 10 options and now it becomes $300.   Your returns have grown for doing virtually nothing. 

So what could go wrong?  Well you get 'called out' which means the stock rises past your $15 contract and you get exercised.  1000 x 15 = $15,000 is now sitting in your brokerage account because you had to sell...and you get to keep the premium you took in of $300.00.  If you like the stock you re-purchase it.  Hopefully, you've done your homework on the channelling and you can repeat this exercise because you really don't want the underlying stock to hit your price.  In your IRA it's not a taxable event...in a brokerage it is.

With the premium you've taken in you can buy more shares of the underlying stock and next month you can 'write' one more option and so on and so on...eventually you'll be taking in a large sum of money every month on a 'non moving stock'.

Questions or comments are welcome as I've simplified a lot of this information.  You can secure options information by calling on the OCC (options clearing corp) to receive the dislosure doc's on options and how they work (calendar and all...free).

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