35 lines
2.7 KiB
Plaintext
35 lines
2.7 KiB
Plaintext
Cl,opter 2: Covered Call Writing 87
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to be accepted or the break-even point will be raised significantly by rolling forward,
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one must consider the alternative of letting the stock be called away.
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Example: A covered write is established by buying XYZ at 49 and selling an April 50
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call for 3 points. The original break-even point was thus 46. Near expiration, suppose
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XYZ has risen to 56 and the April 50 is trading at 6. If the investor wants to roll for
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ward, now is the time to do so, because the call is at parity. However, he notes that
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the choices are somewhat limited. Suppose the following prices exist with XYZ at 56:
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XYZ October 50 call, 7; and XYZ October 60 call, 2. It seems apparent that the pre
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mium levels have declined since the original writing position was established, but
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that is an occurrence beyond the control of the writer, who must work in the current
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market environment.
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If the writer attempts to roll forward to the October 50, he could make at most
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1 additional point of profit until October (the time premium in the call). This repre
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sents an extremely low rate of return, and the writer should reject this alternative
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since there are surely better returns available in covered writes on other securities.
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On the other hand, if the writer tries to roll up and forward, it will cost 4 points
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to do so - 6 points to buy back the April 50 less 2 points received for the October 60.
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This debit transaction means that his break-even point would move up from the orig
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inal level of 46 to a new level of 50. If the common declines below 54, he would be
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eating into profits already at hand, since the October 60 provides only 2 points of pro
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tection from the current stock price of 56. If the writer is not confidently bullish on
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the outlook for XYZ, he should not roll up and forward.
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At this point, the writer has exhausted his alternatives for rolling. His remaining
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choice is to let the stock be called away and to use the proceeds to establish a cov
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ered write in a new stock, one that offers a more attractive rate of return with rea
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sonable downside protection. This choice of allowing the stock to be called away is
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generally the wisest strategy if both of the following criteria are met:
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1. Rolling forward offers only a minimal return.
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2. Rolling up and forward significantly raises the break-even point and leaves the
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position relatively unprotected should the stock drop in price.
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SPECIAL WRITING SITUATIONS
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Our discussions have pertained directly to writing against common stock. However,
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one may also write covered call options against convertible securities, warrants, or
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LEAPS. In addition, a different type of covered writing strategy - the incremental |