Schaeffer's Buy-Write Plus

The buy-write has long been a popular strategy for investors looking to generate extra income from their stock holdings. Essentially, the investor buys a stock they like, then sells (or "writes") a fairly short-dated call on the stock. Typically, the call is slightly out of the money. The theory is that as long as you are comfortable with the stock, nothing bad can happen. Either the stock goes above the strike price when the option expires and is called away from you, giving you a nice short-term profit and an outstanding annualized rate of return, or you keep all the option premium and effectively lower your cost basis on the stock.

For example, let's say you buy XYZ stock at 38 and simultaneously write an XYZ call struck at 40 that expires in two months. You are paid a premium of 2 for the call, lowering your net cost to 36. If the stock closes above 40 when the call expires, the stock is called away from you and you receive 40, for a profit of $4 on a $36 two-month investment, your best-case scenario. This is an 11.1-percent return on capital in two months. If you could do this every two months, you'd be making 67 percent per year without considering the benefits of compounding profits.

Of course, the more likely scenario is that the stock will be roughly unchanged from where you bought it when the short-dated option expires, in which case you would show a profit, albeit a much smaller one. For instance, if the stock did not move at all during the subsequent two months, the option would expire worthless and your stock effectively generated you a better than five-percent (2/38) dividend for the period. Annualize this, even without compounding, and you still make more than 30 percent.

You wouldn't start to lose on the position until the stock drops below 36, where the two-dollar decline in the stock price is fully offset by the pocketed option premium. But you would be subject to much greater potential losses than profits, since you are fully exposed to the stock's downside while your profit is capped at 4 no matter how well the stock does. Of course, this is the same kind of downside exposure you take on when you buy a stock.

But let's say you're intrigued by the idea of making your stocks work hard by generating income, but aren't willing to give up on a possible big winner and don't like the idea that potential losses are much larger than maximum profits. Is there a way to generate income and keep the upside potential?

Actually, there is. We call it Schaeffer's "Buy-Write Plus." The strategy involves using a portion of the premium you take in from selling a call to buy another call with a higher strike price. The call you buy lets you participate in a major upward move, so that you don't have to worry about letting a really big winner get away.

Instead of just selling the 40-strike call, let's say you also bought a 45 call. A trade in which you sell a more expensive option and buy a cheaper one with the same expiration is known as a credit spread. Selling a credit spread against a stock position, in a sense, gives you the best of both worlds. It lets your stock generate income while retaining the chance for significant upside participation should the stock make a big move.

The price of keeping some upside, of course, is a lower return than the standard buy-write if the stock remains flat or trades slightly higher during the options' life. To continue with the above example, let's say you pay 0.50 to buy the 45-strike call. The net premium you collect is now only 1.50 (before commissions). If the stock ends up between 40 and 45 at expiration, it will be called away from you thanks to the sold 40 call. You collect $40 on an investment of $36.50, which is still a 9.6-percent, two-month return that annualizes to more than 57 percent with no compounding. If the stock doesn't move, your effective "dividend" from the net call premium is around four percent (1.5/38), which annualizes to 24 percent without compounding. And your downside protection extends to 36.50 rather than 36.

Saving the best for last, if the stock explodes, you will participate in all upside on a point-for-point basis at any price above 45, the strike of your purchased call. If the stock moves to 48, you would be called out of the stock you bought at 40, but your 45 call is worth 3. Thus, you would collect a total of 43 for a 36.50 investment, translating to 17.8 percent over two months, which annualizes to well over 100 percent without compounding. Plus, your upside is unlimited, unlike the straight buy-write.

Let's look at this example of the stock rising to 48 in a slightly different way. The stock you own gets called away at 40 by virtue of you being short the 40-strike call. But since you own a 45-strike call, you can call away someone else's stock at 45. Thus, you capture three extra points (48-45) you otherwise would not have had if you had only been short the 40 call against your stock. You will find that picking up big incremental gains like this is worth a bit of premium, in this example the 0.50 you gave up by selling a call spread rather than just doing a traditional buy-write. You have to decide if the upside potential beyond the purchased strike is worth the decreased income at the outset of the trade.

The table below shows the returns at expiration over a range of stock prices for the two strategies:

Strategy Pros and Cons:

Pros:

• Lets stocks work for you by generating option income
• Significantly better upside potential than standard buy-write
• Should enhance overall returns under most market conditions

Cons:

• Lower standstill returns than traditional buy-write
• Additional commissions
• Lower income generation means less protection against prolonged downtrend by the stock (i.e., higher cost basis)