Systematic Covered Writing

... more than just covered calls!

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"Systematic Covered Writing is a series of strategies for long-term investors (covered writers) who believe nobody really consistently knows which stock is going to appreciate at any particular point in time. They also believe there are a limited number of possible overall changes in any individual stock's value during a specified period of time and that someday the value of a stock will be higher than when it was originally purchased. Lastly, they understand that their wealth is not emotionally connected to any individual stock held within the portfolio."

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OSIP        OSI Pharmaceuticals Inc.

THE  DATE :   November 3, 2006

THE STOCK: OSI Pharmaceuticals, Inc. - (OSIP) focuses on the discovery, development and commercialization of anticancer medications and treatments for eye disorders.

THE STRATEGY:  The long-term perspective and the effects of Dollar Cost Averaging

THE PURPOSE: The SysCW Dollar Cost Averaging strategy is used when stock lose value.  The premise is to lower the overall cost basis of a position in order to be even in the stock in a lesser period of time.  Basic math tells us that a stock can appreciate by $5 before it can appreciate by $10.

THE COMMENTARY:  There always seems to be two sides to various investing issues.  There are those that contend that a wise investor will establish stop losses.  Take the lumps and move on to more profitable positions is their advise.  The covered writer contends that the only reason for suggesting this is because they have not figured out what to do when a stock does lose value . . . other than to discard it.

It is important to understand that as an investor, one needs to be on one side of the fence or the other.  Setting up investment guidelines is very important for if each position has it's own set of rules, the too much wishy washy emotion comes into play.  Whichever court one decides to entertain, that is the one they should continue to play.  Use the guideline because YOU believe in the process, and not because someone eloquently tells you to do this or that ... just because.  Be sure to separate the rhetoric from the facts.

Having said that . . . the Systematic Covered Writing philosophy is to use Dollar Cost Averaging . . . not stop losses. Many examples have been provided and will continue to be provided.  Why?  Because covered writers use the process as the following example will illustrate. 

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THE INITIAL POSITION: The initial position began in June 2005 with the purchase of 100 shares of OSIP and the sale of the Oct $40 call option. 

The next month, a second Initial Position was established as the stock had appreciated by $3.00 since the position above was established.   Having 200 shares of a stock that was appreciating seemed like a good idea at the time.  The data as of July 2005 was as follows:

The price chart below is a look at the change in value of OSIP from June 28 through September 22, 2005.

The transactions executed on September 22, 2005 were entered only because of the second OSIP position which had the Jan $40 call. With the price of OSIP falling, the writer wanted to 'protect' the $40 strike price.  Here is what is meant by that . . . the writer had no idea where the price of OSIP was going to be in October when the Oct $40 would have expired.  But . . . with the stock falling like a rock, the writer wanted to make sure a $40 strike price would generate enough new cash so the Buy Back & Roll Out math was explored. 

As you can see by the data below, the Oct $40 was closed for a dime and the '07 January $40 LEAP was sold for $3.00. The idea being it would take a while for OSIP to recover, given that it was trading below $30 at the time, so why not add cash to the position while the writer waits for the stock to recover.  Now, both positions have the same strike price, which means they could be combined in January 2007.

For those that advocate some kind of a stop loss, they probably would have exited one or both of these positions.  After all, the $43 stock was trading at $28.65 on September 22, 2005.  The math shows a loss of over 33% in 'value'.  Yes, the value would be down, be the writer is not a short term investor and he or she understands that what the price is 'today' has very little to do with where it will be months later.  It may be higher, it may be lower . . . nobody knows. 

What covered writers do know is if the price stays down . . . there's a plan.  Therein lies the difference between the emotional 'stop the loss' and the 'it's not over until it's over' game plans. Having said that . . . let's extend the time period of the price chart to December 19, 2005.

Notice that from mid October on, OSIP was trading sideways.  Technical analysts would call this 'forming a base', which is generally resolved one way or the other at some point in time.  Here the writer is, sitting with 200 shares of a stock trading below $25 with a net cost basis of $43.09.  (Again . . . what would those that advocate stop losses due . . . the stock is down 42% in 'value'?)

We know what 'they' would do . . . let's concentrate on what a covered writer using the Systematic Covered Writing philosophy would do, which is using the Dollar Cost Averaging strategy to reduce the overall cost basis. As the data below shows, the writer used a combination of Dollar Cost Averaging with the BuyBack & Lower Strategy to not only lower the strike price, but also shorten the duration of the option from January of 2007 to July of 2006.

There are rules to follow when using this strategy:

1. The cash used to close the existing option must be less than the premium received when the new option is sold.

2. The strike price of the new option MUST be higher than the current trading price of the underlying stock.

3. The duration of the option can be no longer than the option that is closed.  When possible, shortening the duration is a bonus.

Check out the Position Tracker and notice how these guidelines were followed with the trading activity that took place on December 19, 2005.  Note that the writer had not idea what the stock would do going forward.  Yes, of course there was the hope that the stock would appreciate, but there was also the awareness that it may not.  Again . . . nobody knows.

Notice that the cost basis is now $34.09 instead of $43.08, and that the new strike price is only about $4 below the stock 'break even' point.  Okay, the story continues by extending the timeline of the price chart to June 13, 2006.

Keep in mind that in June, the position was one month away from expiration.  At that point the writer had two Jul $30 calls written.   At this point the BuyBack & RollOut & Up Math Exercise indicated that the strike could be rolled up to $35 from $30, which would put the position in an Appreciated Trade status.  Recall that this occurs when the strike price is above the net cost basis of the stock. Because the math worked, the transactions were executed.  Note here that this was not a matter of what someone thought or did not think, but rather the result of some pretty basic math.  Oh . . . for sure . . . the writer did need to think of 'looking' at the math!

The updated Position Tracker is presented below.

There are guidelines to the BuyBack & RollOut & Up strategy also, with the key issue being that the cost to close the existing option must be less than the proceeds from the RollOut option.  Way back in 2005, the position began with a $40 January 2007 option, and today the writer is looking at a $35 January 2007 option.  Oh . . . and as of November 3, 2006, OSIP was trading at $38.36.

Pretend that it is January and the option is exercised, which will happen unless the stock falls or the writer intercedes with a BuyBack & RollOut.  Note that about $380 additional profit will be added to this position bringing the total to about $3,130.  Do the math.  That would be a back to cash gain of 23% on a stock that had lost over 40% of its initial 'value'.

Is this a 'satisfactory' position?  YES!  In January IF the calls are exercised, the position would have lasted 571 days and the back to cash net profit would be 14.71% per year since inception.  Is that 'okay'? It is to the covered writer!

One more point having to do with stop losses. If an investor would have 'bought into' the idea of a stop loss in 2005, they would have lost somewhere in the neighborhood of $2000.  This is based on keeping the money that would have been earned by closing the options and losing the money on the stock position.  It works out to being pretty close to two grand when you do the math. 

Here is the point . . . in order for the investor who follows the stop loss approach, they would need to not only make up the $2000 they really would have lost by closing the position, but also the $2,759.34 that would have been generated by simply staying the course.  This is obvious because if a loss is created, one has to make up that loss 'just to be even'.  This is a very important concept to have in the memory bank.

Along with the idea just mentioned, is the probability issue.  Which stock has a higher probability of appreciating?  One that has recently lost significant value or one that has been appreciating.  In other words . . .every time a stock is selected, the investor is rolling the dice.  Why?  Because when all the technical analysis and fundamental analysis has been completed . . . the reality is . . . nobody knows.

It is very likely that as a subscriber, you will see numerous 'new' Dollar Cost Averaging positions via the continuing flow of examples.  When you see one, remember examples like this one.  The strategy is used because it works . . . and it works because the strategy is used. Dollar Cost Averaging is part of the Systematic Covered Wring process.

_______Update January 2007______

THE COMMENTARY:  The Buy Back & Roll Out was used to generate additional cash from this position.  The current Jan $35 option was due to expire in one day, but the writer elected to roll the position early in order to protect the value of the $35 strike price.  This time, the position was extended for only one month!  Take a look at the data to date:

The net gain of $418.31 may not seem like much, but given that the strike price is above the net cost basis, what if the writer could do that every month?  At this point, the writer is willing to go the short-term route because the downside protection is already 'in the bank'. 

FINAL THOUGHT:  Yes, I am going to mention the 'value' issue.  A stock that was at $41.46  . . . traded as low as $20.81 on October 21, 2005, but thanks to not giving up and the prudent use of the Dollar Cost Averaging strategy is now trading very close to the net cost basis AND has generated over 23% of the total amount invested. Rather than 'worrying' about a stock that went from $41.46 down to $20.81, the covered writer focuses on the philosophies of Systematic Covered Writing.

 

Click March 2007 Update . . .

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PLEASE NOTE THAT THIS EXAMPLE IS NOT TO BE CONSIDERED AS A RECOMMENDATION TO INVEST IN OSIP STOCK OR ANY OTHER EQUITY.  THE INFORMATION IS PROVIDED FOR EDUCATIONAL PURPOSES ONLY.  THERE IS NO GUARANTEE THAT SIMILAR TRANSACTIONS CAN BE EXECUTED IN THE FUTURE. INVESTING IN THE STOCK MARKET INVOLVES RISKS, DO SO ONLY WITH A KNOWLEDGE AND UNDERSTANDING OF THE RISKS INVOLVED!

The information provided above is for informational purposes only, and no mention of a particular security constitutes a recommendation to buy, sell, or hold that or any other security, or that any particular security, portfolio of securities, transaction, investment strategy is suitable for any specific person. You further understand that the Covered Writer will not advise you personally concerning the nature, potential, value or suitability of any particular security, portfolio of securities, transaction, investment strategy or other matter. To the extent any of the information available on this website may be deemed to be investment advice, such information is impersonal and not tailored to the investment needs of any specific person. Always remember that past results are not necessarily indicative of future performance.

These are the terms of use.  Why are they here?  Because the examples provided are real.  The transactions actually took place.  The dates are real, the positions are real.  Some transactions will have been executed on the day you receive the email.  What you are agreeing to, is the fact that in no way is it being suggested that you can, or should, enter a similar position.  Why?  Because that would be providing investment advice and the Covered Writer is not authorized to do that.  There is also no guarantee that similar transactions could be executed at any time in the future. Only licensed brokers are allowed to provide investment advice.  Therefore, you are agreeing that the preceding example was provided for 'educational purposes' for the sole purpose of illustrating the Systematic Covered Writing strategies.

Thank you!

SYSTEMATIC COVERED WRITING
Copyright © 2006. All rights reserved.
Revised: 03/17/07