Buy-Write Strategy: What are the best market conditions?

RichKid · 10 May 2006

I've been looking over this new offer of a listed buy-write fund: http://www.aurorafunds.com.au/aurora-home.htm

It looks like the best time to write calls is when prices are going down or sideways (if you are the writer); that appears to be the conventional wisdom- see the ASX fact sheet in the link above (the red brochure). Volatility appears to be historically low for the local stockmarket so that would be another benefit, more bang for your buck. I'd forgotten that they had a buy-write index as well, guess more research for me, might be a good diversification tool when things get choppy.

Any thoughts generally on the best conditions for such a fund strategy?

We still seem to have some puff left in the old bull so it may be safer to get into it later, having said that it's tough to call a top, we could just drift up and down for a year or two and then crash....or we may just keep powering on with exhaustion years away. Merril Lynch is managing it, not sure what their record is, I don't think they do any market making.

chemist · 11 May 2006

RichKid said:
I've been looking over this new offer of a listed buy-write fund: http://www.aurorafunds.com.au/aurora-home.htm

It looks like the best time to write calls is when prices are going down or sideways (if you are the writer); that appears to be the conventional wisdom- see the ASX fact sheet in the link above (the red brochure). Volatility appears to be historically low for the local stockmarket so that would be another benefit, more bang for your buck. I'd forgotten that they had a buy-write index as well, guess more research for me, might be a good diversification tool when things get choppy.

Any thoughts generally on the best conditions for such a fund strategy?

We still seem to have some puff left in the old bull so it may be safer to get into it later, having said that it's tough to call a top, we could just drift up and down for a year or two and then crash....or we may just keep powering on with exhaustion years away. Merril Lynch is managing it, not sure what their record is, I don't think they do any market making.

buy-writes are equivalent to short puts (besides some hair-splitting over franking credits), so the best market conditions are flat or bullish. I don't see why low market volatility is necessarily an advantage: an option writer wants low realized volatility relative to implied.

cheers,
chemist

money tree · 11 May 2006

The downside risk here is too great.

XJO has added 100% from Mar 2003 low.

One rule I have for buy-writes is that dividend yields must be high enough to support the share price.

if div yield is 3.5%, it is possible to see a 50% drop in share price.
if div yield is 7%, it is very difficult to see a 50% drop in share price.

As I have said many time, a buy-write strategy will ONLY add 5% to a buy & hold return. Why bother? There are many other strategies with better returns & less risk.

RichKid · 12 May 2006

chemist said:
buy-writes are equivalent to short puts (besides some hair-splitting over franking credits), so the best market conditions are flat or bullish. I don't see why low market volatility is necessarily an advantage: an option writer wants low realized volatility relative to implied.

cheers,
chemist

Wouldn't it be flat to bearish that is best- ie you sell the call for a higher price than the market and sell as the mkt falls (or keep the premium if it goes nowhere)?? If the mkt is bullish and the sp rises then you get called and you lose profits...or maybe I'm too new to this and don't understand it.

MT
Thanks for the info, with the fund, it's run by someone else so no work once you buy in and lots of leverage.

chemist · 12 May 2006

RichKid said:
Wouldn't it be flat to bearish that is best- ie you sell the call for a higher price than the market and sell as the mkt falls (or keep the premium if it goes nowhere)?? If the mkt is bullish and the sp rises then you get called and you lose profits...or maybe I'm too new to this and don't understand it.

If you are short a put you want it to expire out of the money.

chemist

newSPIer · 12 May 2006

You have it the wrong way around.
When the security price falls you may keep you premium but you start lossing on the security fast. You don't buy something if you have a flat/bearish outlook.
Buy/Writes are for a flat/bullish outlook as when the market turns bullish your proift gets locked in, rather than being lost.

Have a look at the option strategy section on asx website it is quite comprehensive.

I find the bid/offer spread on ASX options too big for buy/writes (or short puts) to be that profitable.

money tree · 12 May 2006

I think people misinterpret the common belief that the buy-write is suitable for a flat or bullish view.

This does not mean that it is suitable in a bullish market. It must be flat, or slightly bullish. A raging bull run like we have had the last 3 years is NOT suitable. However, the previous 3 years were perfect.

wayneL · 12 May 2006

Agree with MT here.

I would add only one point, and that is the difference between a buy/write and a covered call. Yes exactly the same strategy, but an entirely different philosophy.

We can describe the buy/write as buying shares and concurrently sell calls over them with the express purpose of collecting the call premium, exclusive of other considerations. We don't care if the shares get called, it's the premium we want. In this case we most definately want a sideways to up. But the risk, and it's a big risk, is to the downside. In my view, and as MT has pointed out also, there are better, less capital intensive, lower risk strategies to collect premium with.

The buy/write is not a good strategy. IMO

On the other hand, the covered call can be described as selling calls over share that are already existing in our portfolio. These are shares we definately don't want to sell (precipitating a capital gains event) or be called away. But because the shares are going sideways, or down, (and we still want to hold for the long term) we want to extract some additional income by selling calls over them. In this case we want a sideways or down market (well we don't really want down) What we are simply doing is extracting income from a non performing share.

The covered call in this particular instance is an excellent strategy.

Same strategy - different philosophy.

money tree · 12 May 2006

I went to a Peter Spann seminar about a year ago.

He called it the "magic moo-cow" or something. Spruikers often rename an existing strategy then trademark it to make it sound like their brilliant idea. He was quoting 6% a month. When he said this I did a "cou..(BxxLSHxx)..gh" and a lot of people mumbled, a few giggled and Spann did nothing more than turn his eyes in my direction for a split second.

He then went on to "prove" that those returns were possible. To do this, he quoted ASX figures on NCP during Nov/Dec 1999.......gee, no bias data there!

As wayne has pointed out, there are subtle differences between strategies (whatever you want to name them).

As wayne and I have often said, a buy-write is identical to a short put in risk/reward payoff. How odd that people would not dare write naked puts, yet are quite happy to do a buy-write. I should add, that a buy-write is SAFER and has a HIGHER return than a buy & hold strategy. So we are taking LESS risk than normal.

As wayne pointed out, you could argue a difference between a buy-write and a covered call. But there is also a third strategy. Instead of coming up with say $200k for the FPO purchase, and then writing calls over them for around 5% p.a (actual write is around 2% per month but this does not take into account buybacks).....why not forget the FPO purchase, and simply write puts? Its the same risk/return remember! see:

http://posigear.8k.com/custom3.html

dont need $200k for that!

If you ever get assigned, you now own the stock, so start writing calls. Take a synthetic buy-write and turn it into a real one.

Option A:

buy-write
Capital = $200k
Premium - $10k p.a
Return - 5%
Risk factor - FPO x 0.95

Option B:

synthetic buy-write
Capital = $10k
Premium - $10k p.a
Return - 100%
Risk factor - FPO x 0.95

hey wayne.....we should be on the seminar circuit!

RichKid · 13 May 2006

Thanks everyone for the great discussion, very informative, love the magic moo cow story MT....and yes, you guys could call yourselves the 'Wayne & Money' show or something...like a travelling troupe of options artists (especially with those colurful charts of yours Wayne, pure masterpieces imo, show em a few volatility skews too for that extra dazzle factor). (excuse the puns)

wayneL · 13 May 2006

money tree said:
hey wayne.....we should be on the seminar circuit!

Well we'd have to give out better info than magic moo-cows and "renting shares" (gawd how I detest that phrase)

But I often wonder whether the typical seminar attendee actually wants the fair dinkum truth of option trading (which is pretty damned good anyway if done properly) or the syruppy, dangerous BS that the majority of seminar promoters (note I didn't say educators, because thats not really what they are) crap on with.

But, geez I'd have to get a haircut

money tree · 13 May 2006

wayneL said:
But I often wonder whether the typical seminar attendee actually wants the fair dinkum truth of option trading (which is pretty damned good anyway if done properly) or the syruppy, dangerous BS that the majority of seminar promoters (note I didn't say educators, because thats not really what they are) crap on with.

Judging by the number of people paying $5k for seminars and the lack of people paying $590 for my course, it seems they want the latter....

chemist · 13 May 2006

wayneL said:
Agree with MT here.

I would add only one point, and that is the difference between a buy/write and a covered call. Yes exactly the same strategy, but an entirely different philosophy.

We can describe the buy/write as buying shares and concurrently sell calls over them with the express purpose of collecting the call premium, exclusive of other considerations. We don't care if the shares get called, it's the premium we want. In this case we most definately want a sideways to up. But the risk, and it's a big risk, is to the downside. In my view, and as MT has pointed out also, there are better, less capital intensive, lower risk strategies to collect premium with.

Would you suggest bear spreads?

bowser said:
The buy/write is not a good strategy. IMO

I always thought if you want to make money for taking on the downside exposure, why not stop kidding yourself and just write a put?

bowser said:
On the other hand, the covered call can be described as selling calls over share that are already existing in our portfolio. These are shares we definately don't want to sell (precipitating a capital gains event) or be called away. But because the shares are going sideways, or down, (and we still want to hold for the long term) we want to extract some additional income by selling calls over them. In this case we want a sideways or down market (well we don't really want down) What we are simply doing is extracting income from a non performing share.

The covered call in this particular instance is an excellent strategy.

Same strategy - different philosophy.

Sure, for rusted-on buy-and-holders writing calls might sometimes be better than what they're doing now, but changing their attitude might be better still. In some ways the short call has a psychological function: it is giving them a guilt-free way of selling a share.

Chemist

sails · 13 May 2006

money tree said:
Judging by the number of people paying $5k for seminars and the lack of people paying $590 for my course, it seems they want the latter....

It's the NLP style marketing which sucks people in.

We did one expensive options course on the understanding that it would give a complete options education with life time repeats, but sadly found that we had only purchased the basics and to complete the entire course added up to about $30K plus airfares + accom. to the US. Thankfully we paid no more and I settled in to studying books, learning all I could from the internet for free which was the best decision.

Mofra · 13 May 2006

Given flat to slightly bullish market conditions I would prefer a put bull spread than a straight put write or a covered-call sort of strategy.

Horses for courses and I suppose with time everyone finds out what strategies they are most comfortable with and what their own risk profiles are like.

wayneL · 13 May 2006

Chemist,

What's this "bowser" business? I hope it is meant as a genuinely and sincerely complimentary I have access to the little red button you know :batman:

Would you suggest bear spreads?

That would depend on a few factors, your precise (or imprecise) view of likely market direction and volatility, time frame, current IV etc. But a bear spread could be one answer... or part of the answer.

I always thought if you want to make money for taking on the downside exposure, why not stop kidding yourself and just write a put?

Indeed! But why leave open ended risk? ...unless you don't mind ending up with the shares. You only have to get wacked by a fat tail once, to realise an OTM guard is both cheap and makes good sense. Mofra's got the idea.

But it is still only one approach out of many and may be appropriate or not, depending on the circumstances.

Curiously, as per MT's post below, traders recognise the indeterminate risk in the naked written put, but fail to see it in the buy/write????

Sure, for rusted-on buy-and-holders writing calls might sometimes be better than what they're doing now, but changing their attitude might be better still. In some ways the short call has a psychological function: it is giving them a guilt-free way of selling a share.

I've never thought of it that way. But I wouldn't be surprised such crippling psychology exists. But then again, all of us have a psychological Achilles Heal ...somewhere! Dealing with that would indeed be better still. But for most people there must be the recognition of the problem and the desire to fix it. But it is still a process rather than a Quick Fix.

Cheers

chemist · 15 May 2006

wayneL said:
Chemist,

What's this "bowser" business? I hope it is meant as a genuinely and sincerely complimentary I have access to the little red button you know :batman:

Holy terminating typos Batman! some weird editing error... apols.

wayneL said:
That would depend on a few factors, your precise (or imprecise) view of likely market direction and volatility, time frame, current IV etc. But a bear spread could be one answer... or part of the answer.

Indeed! But why leave open ended risk? ...unless you don't mind ending up with the shares. You only have to get wacked by a fat tail once, to realise an OTM guard is both cheap and makes good sense. Mofra's got the idea.

But it is still only one approach out of many and may be appropriate or not, depending on the circumstances.

Curiously, as per MT's post below, traders recognise the indeterminate risk in the naked written put, but fail to see it in the buy/write????

Sure. For these people a naked put is scary, buying shares is not.

To me it boils down to whether it's better value to write a deep OTM put or buy one. I'm not convinced by Taleb's arguments that it is always better value to buy such options. A lot of poor traders might buy them basically as lottery tickets, and lottery tickets are generally better value for the seller than the buyer.

cheers,
chemist

wayneL · 15 May 2006

chemist said:
Holy terminating typos Batman! some weird editing error... apols.

Sure. For these people a naked put is scary, buying shares is not.

To me it boils down to whether it's better value to write a deep OTM put or buy one. I'm not convinced by Taleb's arguments that it is always better value to buy such options. A lot of poor traders might buy them basically as lottery tickets, and lottery tickets are generally better value for the seller than the buyer.

cheers,
chemist

In principle I totally agree. But because of the very skinny premiums of OTM put, what a lot of people do is write lots and lots of contracts to make up a decent total premium. But now we have a truly massive position in the underlying.

If the stock starts moving down quickly, it will start developing one hell of a lot of delta as.... and as we go towards the money, we go towards maximum gamma territory. The delta developing can be truly frightening. Yes you can defend, but what about a nasty gap?

One could find themselves in 100% delta territory on a whopping position size and staring financial ruin in the face.

They will come for your house, your car.... your firstborn if necessary.

As someone famously said, it's picking up pennies in front of a steam roller.

Yet by simply spreading off the risk with some bought further OTM options, we can defend against the financial apocalypse. This leaves us also, with more defence options... hedge, roll, condor, flip... or all of 'em... and without blowing out margin.

I think Talebs strategy is good as it provides liquidity for those of us taking the other side

Mofra · 16 May 2006

wayneL said:
Yet by simply spreading off the risk with some bought further OTM options, we can defend against the financial apocalypse. This leaves us also, with more defence options... hedge, roll, condor, flip... or all of 'em... and without blowing out margin.

Many of us "intrinsic salesmen" wouldn't consider a position without downside (or upside) protection anyways, simply because without accurately quantifying your net risk, how can you plan your position size with any certainty?

wayneL · 16 May 2006

Mofra said:
Many of us "intrinsic salesmen" wouldn't consider a position without downside (or upside) protection anyways, simply because without accurately quantifying your net risk, how can you plan your position size with any certainty?

Imagine being short a few too many puts on this:

Buy-Write Strategy: What are the best market conditions?

RichKid

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chemist

money tree

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