Four Ways Buy-Write Can Go Wrong

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Four Ways Buy-Write Can Go Wrong

Courtesy of Steve Smith at Minyanville

One of the biggest myths I try to dispel is the notion that covered calls, or buy-writes, are a safe, conservative strategy. This is the strategy that involves buying stock (or already being long shares) and then selling call options as a means to collect premium.

Buy-writes are among the popular strategies for the general investing public, and are peddled by brokers as a safe way to earn income and reduce risk. The big selling point is usually that even if the stock stands still, one can earn 20-40% annually by selling calls each month. The second benefit promoted is that call premium collected reduces your affective purchase price, and therefore acts as downside protection or a form of a hedge.

The 2 main problems are:

1. Stocks rarely stand still (just look at  big beta names like Apple (AAPL) Google (GOOG), or Research In Motion (RIMM). In other words, annualizing returns has the fallacy of assuming a one-time event can be repeated over and over and produce the same results.

2. The amount of premium collected is usually a fraction of the price of the underlying shares. In other words, the risk of a covered call is only marginally lower than owning the stock outright.

If there’s any doubt about the risk of a buy-write, remember it has the same profile as selling a put. If you would never sell a naked put, than you should never establish a buy-write.

Reaching for the Stars

In early June in the OptionSmith newsletter (click here for free trial), I recommended and established a buy-write in Star Scientific (STSI) when shares spiked above the $5 level. It appeared that the company might win its patent lawsuit against RJ Reynolds (RAI). The final decision was pending, and option premium was pumped above the 250% level in anticipation.

Now, in my defense, I wasn’t using this strategy as income generation, nor did I intend to keep rolling it. It was a trade ahead of an event. My thinking was that a positive ruling would push the stock through the $7.50 strike of the calls I sold and yield a decent profit. If the news was negative, the stock would slip back to the $4 it had been trading during prior months. A loss would be incurred, but it would be manageable, thanks to the $0.65 of call premium I collected.

Falling Down to Earth

Last night the ruling was handed down, and it was not in Star Scientific’s favor. The stock plummeted and is currently trading below a buck. Of course there’s talk of a new trial, a possible appeal, and so forth. But this trade is over. The lumps have been taken. The loss is nearly 4 times the average risk I like to assume on any given position.

Now I just have to get through a day of the "woulda, shoulda, couldas" — the likes of which are cropping up because twice I’d entered limit orders to close the position: one last week — when the stock was above $5 — and one on Monday to sell it at $4.95. It traded as high as $4.90 share.

In trying always to learn from mistakes or from what went wrong, there are 2 takeaways:

1. Don’t ever underestimate risk, especially in supposedly conservative positions such as covered calls.

2. Don’t try to squeeze a nickel or dime when looking to exit a position. If you decide it’s time to close a position, do it. Use a market order and move on.