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Buy-Write
The Smart Profits Report: Issue #130
Thursday, July 29, 2004
Buy-Write: Predict Your Profits With 99.7% Accuracy
By Karim Rahemtulla
Investment Director, Mt. Vernon Research
One of the most rewarding options strategies for me has always been covered calls - writing an option against a stock you already own to, essentially, buy the stock at a discount (the premium you receive from selling the call subtracted from the stock’s price). But this strategy can be difficult to execute in real life. Why?
Well, because trying to get filled on your stock order AND your option order - both at your target prices - is nearly impossible. Impossible, that is, unless you understand the art of a little-known technique called a “buy-write.”
By learning how to use this simple, powerful options tool, you can ensure that you either:
- Get into each trade at the prices you want, and thus secure optimum profits from each trade
- Don’t get into the trade at all, and thus ensure that your trading capital is reserved so you can “fight another day.”
Let me explain…
How to Buy Right with a “Buy-Write”
There are several methods of executing a covered call trades depending on the type of account you have and your tolerance for risk. One of the most common is a “market order”: a simultaneous trade “at the market.”
But market orders are not advisable because you are basically saying, “Fill me at whatever price is out there.” (And considering that an options market maker can manipulate option prices almost at will, the risks are obvious.)
The other way is to use a “limit price” on the stock, check the execution, and then when you’re filled, put in your option trade using another limit order.
But there is a third way that will bring you increased piece of mind, while also providing you with the highest possible profits on each of your covered call trades: having your broker execute a buy-write.
Why Prodding Your Broker Can Bring Electric Results
He might be reluctant when you first bring up this technique, but don’t let your broker talk you out of it. Buy-writes take a little more time and attention for him to pull off, but it’s worth it (and even accounting for occasional human error, a decent options broker should be able to successfully handle a buy-write, say, 99.7% of the time).
A buy-write requires you to set two specific prices at which you want the entire order to be filled: one target price for the stock and one for the option you’re selling against the stock. (The net cost, or “net debit,” is the “discount price” you pay for the stock once the option premium you make is deducted from the stock’s price…)
Let’s say you like Lucent Technologies at $3 and you want to sell the $3 call option against it. The option is trading for $0.25 on the bid and $0.35 on the offer. You can tell your broker to execute a buy-write in which he:
- Buys Lucent stock at $3 a share…
- Sells the same number of Lucent calls at $0.25…
- Or, if he can’t reach your “net debit” target, he doesn’t execute any trade at all…
This buy-write would guarantee that you either pay a net cost (or net debit) of $2.75 per share, or back away from the table.
You’re also guaranteed NOT to play the whack-a-mole game of chasing a stock price and an option price simultaneously, or asking your broker to make an attempt at this impossibly frustrating task.
Exactly How a Good Buy-Write Is Executed Online
Here’s exactly how that Lucent trade would go down if you were using an online broker…
- Buy 1,000 shares of Lucent (no price entered on the buy-write screen)
- Sell 10 contracts of the Lucent option (you must enter the symbol - again, no price is entered)
- Then on the following line it asks for the “net debit.” This is where you enter your net target price. In this case you would enter $2.75 as your net debit.
What this means is that the trade will NOT be executed until and unless your net debit price is met. Period. No ifs ands or buts. If you felt a little greedier - after all, each penny counts - you could enter a net debit of $2.72 for an extra 3 cents. You will most likely get filled at some point, unless your spread is absurd.
The only downside to this type of trade is that you may have to wait a while to get filled. It’s not exactly waiting for the sun, moon and planets to line up, but it is a trade that is basically done at the broker’s convenience, not yours.
And while the time element isn’t fully within your control, the pricing element is - and that means you DO control your profits.
Good Trading,
Karim Rahemtulla
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Today’s Smart Profits Cribsheet
- For detailed explanations of options-trading terms such as “buy-write” and “market maker,” check out our Smart Profits Glossary.
Related Articles:
- Deep-in-the-Money Covered Calls: How to Beat Stocks with Way Less Risk
- Writing Covered Calls: How to Double Your Stock Profits with Options
- Market Makers - Hand Signals, Stress and Million-Dollar Trades
