Systematic Covered Writing

... more than just covered calls!

STRATEGIES IN USE

EXAMPLE  DATE :    January 30, 2007

THE STOCK:  Cyberonics Inc. - (CYBX) This company designs, develops, makes and markets medical devices for the treatment of epilepsy and other neurological disorders through vagus nerve stimulation.

THE STRATEGIES: Initial Position, combining positions, Buy Back & Lower, Buy Back & Roll Out &Up, Recover After Expiration.

THE THEORY:   History continues. In many of the examples provided in the tutorial, the transactions took place in 2005 and early 2006.  This example is provided to illustrate the effectiveness of Systematic Covered Writing through a variety of  market conditions in terms of the value of the underlying stock. The key to the success of SysCW is having a plan, and then working that plan. The theory underlying all that follows is the concept of being paid because a stock position is owned, and not because it increased in value.

Covered call positions where the stock increases in value will be assigned.  This is perfectly okay!  The position goes back to cash with the predetermined profit.  We are not 'worried' about positions that 'work'.  It's all the other positions that cause fear and uncertainty.  SysCW provide the process for handling situations like this.

THE COMMENTARY:     Let's begin with the entire history of this position from June 2005 to January 2007.

Before continuing, let's look at the price history of this stock over the holding period.

The red horizontal lines indicate the strike price location during various periods of time. The three vertical lines in the June-July 2005 area represent the purchase points.  Note that the stock was appreciating when the Initial Positions were established. Now let's look at the events.  Please note that the writer has no idea what the price will be when a strategy is used, yes, we are looking at this in hindsight, but that is this point.  In order for an idea or strategy to work in the future, it seems rather important that it also worked in the past, and is still working in the present!

June/July 2005	Three Initial positions were established with three different strike prices.
July 29, 2005	The Buy Back & Lower strategy was used to close the Aug $45 call and open the Aug $37.50 call. The purpose of this strategy is to increase the amount of cash generated over the same time period.  Note that the 'investment' amount remains constant. The other reason for doing this is it created a 2 contract position for this option. See that $38.25 was used to close the $45 call, but $191.74 was generated when the $37.50 option was sold.   (Cash was added.)
August 19, 2005	The two $37.50 calls were rolled up to the $40 strike price as the stock was trending higher. The idea being that selling the stock for $37.50 would not be advantageous at the time.  As you can see be the chart, the rally was rather short lived. Also note that the reason the strike price could be lowered on July 29th is because the writer has a plan if the price of the stock moves above the lowered strike!  That 'plan' is the Buy Back & Roll Out & Up strategy. If you know what you are going to do if this or that happens . . . it is really not an issue 'doing it'.
November 21, 2005	Both existing options were closed (bought back) and three contracts of the '06 Jan $30 calls were sold.  This was a double application of the Buy Back & Lower strategy as all three contracts where now established at the Jan $30 strike price. Look at the math.  On the same day the writer spent $88.25 plus $69.50 to close the existing options, and then turned right around and generated $589.22 with the new option position.  Keep in mind that the 'investment' remains the same.
January 13, 2006	Here we go again . . . CYBX was trading above the $30 strike price and the writer used the Buy Back & Roll Out & Up strategy to protect the stock from being assigned, AND add cash to the portfolio. The writer used $535.75 to close the three '06 Jan $30 calls, and then immediately sold three '07 Jan $35 LEAPS for $1,489.20.  Cash was added to the account . . . the 'investment' generated more cash.
June 6, 2006	Of course, as soon as the writer increased the strike price, the stock loses value. This is all part of the philosophical reality behind the SysCW expression . . . nobody knows! What does a writer do?  How about the Buy Back & Lower strategy to generate additional cash without increasing the duration of the option. The writer spent $175.75 to close the '07 Jan $30 calls, and then took in $439.23 with the sale of the three '07 Jan $27.50 calls.
January 2007	On January 20, 2007, the $27.50 calls expired leaving the writer with 300 shares of CYBX. On the Monday after expiration, three contracts of the Apr $25 calls were sold using the revised Recover After Expiration strategy of Systematic Covered Writing.

Over the entire holding period, the net total investment of $12,199.80 has generated a total of $4,717.23 in cash, or 38.67% of the funds invested in this holding.

Let's Talk About Value

When an investment is made in an equity position, which could be a stock holding, a mutual fund or an option holding (long in every case), the only way the investor can create a profit with the investment is IF it appreciates and IF the investor liquidates the position at the elevated price. There are many investors that try to accomplish this desired result, using a variety of methods or strategies. Unfortunately, the general public is conditioned to think that this is HOW one makes money in the stock market. The unfortunate effect of this conditioning is the focus on 'value'.  "What's my stock worth?"  Hopefully, you have a 'feel' for what I'm talking about.

Some stocks that are purchased using the IF Investing strategy (what was just described) actually do appreciate and profits are generated.  BUT . . . some stocks lose value and are sold at a loss for two reasons.  One, there is no 'plan' for stocks that lose value, and two, because there is no plan, fear and anxiety take over.  It's an emotional rollercoaster. Right?

Enter Systematic Covered Writing: Positions are established with a predetermined back to cash profit IF the option is exercised, and a plan for further cash generation IF the option is not exercised. Now someone might say . . . "Wait a minute, there are two IFs in this strategy as stated!" Correct, but actually it should be noted that one or the other WILL take place.  For the stocks that are assigned, the position generated the desired level of return.

For the stocks that are not assigned, the writer uses the expression . . . they are just not over yet!  With these thoughts in mind, let's get back to the example. . .

Note that this example is just one example dealing with that second IF. That being the Initial Call Option is not exercised.  So now I ask you . . ."IS THAT BAD?". The writer makes an investment, which in this case happens to be $12,199.80.  That investment has lost over half it's value!  The net cost basis is $40.67, and the current trading price is $20.80 (its been lower). The reason the writer is not 'worried' is because there is no reason to sell the stock.  The investment is still doing what it is supposed to do, in spite of the loss in value.

The Recover After Expiration strategy currently being used it to sell a close in option (short-term) with the object being to generate cash at a reasonable rate while waiting for the stock to appreciate.  What is a reasonable return? I don't know . . . tell you what . . . write down a return that you would be happy with for a position that has lost 1/2 of it's value.   Seriously . . . write it down.

The Apr $25 call was sold for a net cash addition of $229.24.  The writer could have generated more if the $22.50 strike price were used. In this case, the writer decided that additional would be sacrificed for the security of the higher strike price. The decision was easy to make because the position has already generated over 38% in about 19 months.  Reason one.

Reason two is this new option has a duration of three months, which means it could be repeated four times in a year.  Okay, four times $229.24 is $916.96.  If you divide the current cash generation rate by the net investment , you would find that the investment is still generating cash at the rate of 7.51%.  So here we have a 'lousy' position that is currently generating cash at 7.51% annually, and to date has generated over 38% in cash dollars.

See the difference?  With IF investing, the investor is constantly faced with the fear of loss in value, because that is what they have been taught.  Hey . . . if you are an IF investor, let me be the first to say you should have that fear!  There is no reason not to have it. On the other hand, if you invest with a plan that covers both the upside and the downside of changes in the value of a given stock, then there is no fear! The key to having this philosophy is a commitment to being a long-term investor.

I did not select this position because the results were outstanding.  It was selected because the stock has lost a significant amount of value.  Does the writer 'like' that?  No way!  But the writer deals with it  . . . one covered call at a time!

Some positions end as planned.  The Initial Call Option is exercised and the stock is assigned.  Others . . .  just aren't over yet! With rare exception . . . those are the only two choices in the covered writer's methodology of investing.

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PLEASE NOTE THAT THIS EXAMPLE IS NOT TO BE CONSIDERED AS A RECOMMENDATION TO INVEST IN CYBX 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 suggesting 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 provide 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: 02/02/07