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 EXPERT PANEL |
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Ask the expert
Buy-write strategies
Matt Comyn, General Manager, CommSec
What is a buy write option strategy and what are the benefits and potential risks using this strategy?
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Today's expert:
Matt Comyn, CommSec | A buy write option strategy involves the simultaneous purchase of underlying shares and sale of a corresponding call option. By selling a call option against our shares we are giving someone the right to purchase our shares at a specified price up until the expiry of the option, and for this we receive the option premium in the form of income.
Consider for example XYZ shares which are currently trading at $30.00. We decide to purchase 1000 shares at $30.00 and at the same time sell an XYZ call option with an exercise price of $31.00 expiring in 2 months for a premium $0.70. Generally the trader’s outlook for this particular strategy is for the share price to remain relatively steady over the next two months. Therefore if the share price finishes below $31.00 at expiry, the call option will expiry worthless and the trader retains the shares and also the full option premium.
The benefit of the buy write strategy is the trader generates income from their shares. The receipt of the option premium can be considered a discount to the purchase price i.e. our effective purchase price for XYZ shares would be $29.30 (30.00 – 0.70). So where our breakeven point was previously $30.00, by selling the call option we have effectively lowered our breakeven point to $29.30. Therefore we do not suffer a loss unless the share price falls below this point.
A disadvantage of the buy write strategy is the opportunity cost in the event the share price rises strongly above the exercise price of the sold call. In this case we will be forced to sell the shares at the lower exercise price, limiting our profit to the difference between the exercise price and the purchase price of the shares plus the option premium. In the example of XYZ our maximum profit is $1.70 (31.00 – 30.00 + 0.70).
Deciding on what exercise price to sell the call at will largely depend on the trader’s outlook for the stock and also their willingness to be exercised. The deeper the call option is out-of-the money the more they participate in any upside share price movement and also the less likely they are to be exercised. However the further out-of-the money the option is the less premium the option will attract.
When implementing the buy write strategy traders need to be cautious of which underlying share they purchase as they are still exposed to a decline in the share price. Although the sale of the call lowers the breakeven point, therefore cushioning any fall in the share price, the trader still faces potential losses below this point. This is however no more risky than buying and holding shares. For this reason I suggest whenever doing a buy write strategy the trader selects shares in which they are comfortable owning.
Like any strategy, entering a buy write position will largely depend on the trader’s outlook for the underlying stock, attitude toward risk and investment timeframe.
Disclaimers
The views expressed in this article are those of Matt Comyn, a representative of Commonwealth Securities Limited (CommSec) ABN 60 067 254 399 AFSL 238814. Commonwealth Securities Limited (CommSec) ABN 60 067 254 399 AFSL 238814 is a wholly owned but non-guaranteed subsidiary of the Commonwealth Bank of Australia and a Participant of the ASX Group. As this information has been prepared without considering your objectives, financial situation or needs, you should, before acting on this information, consider its appropriateness to your circumstances and if necessary, seek appropriate professional advice. Exchange Traded Options are issued by Commonwealth Securities Limited ABN 60 067 254 399 AFSL 238814. A Product Disclosure Statements is available by calling 13 15 19 (8am-7pm Monday to Friday, EST) or by visiting commsec.com.au. You should consider the appropriate PDS before making any decisions about the products.
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