BUY BACK & LOWER
Cash generated per unit of time is one of the guiding factors to managing positions within a Systematic Covered Writing Portfolio. The purpose of the BB&Lower strategy is to increase the amount of cash generated, without extending the expiration date. This strategy is used when a stock loses significant value significantly prior to the current option’s expiration. Keep in mind, that as increased cash is added, increased risk is assumed.
RULES
The strike price of the replacement option (the Lower) needs to be lower than the existing (the Buy Back) option.
The amount received from the sale of the Lower option needs to be greater than the amount paid to Buy Back the existing option.
The strike price of the Lower (replacement) option should be above the current trading price of the stock, although if a stock seems to be losing value, this suggestion can be overruled. Again . . . the lower the strike price the higher the risk.
When would a covered writer consider using this strategy, and for that matter - WHY? Imagine a position where the current option is above the trading price of the stock. What does the relationship between the strike price and the trading price of the option indicate? The answer involves a basic understanding of a covered position and is simply that unless the stock increases in value, the option will expire without being exercised. Next, consider the value of this option.
For any option strike price above the trading price of the underlying stock the only 'value' the option can possibly have is the perceived value that the stock's price will increase before the option expires. Think about it . . . the right to buy a stock for $40 a share, when the stock is trading at $38.00 a share is worthless - unless the price of the stock moves above $40. In other words, what good is a right to buy something for $40 when it can be purchased for $38.00? The only value this option could possibly have is the perceived or 'extrinsic' value.
Extrinsic value has two basic components. First, the longer the duration of an option, the higher the extrinsic value. Why … because the underlying stock has more time to appreciate, which is the 'bet' that is being placed when a call option is purchased. The other component is very complex, for the sake of this discussion; let's just call it the expectation value that the stock really will appreciate. The greater the expectation the stock will appreciate from $38 to $45 (for example), the greater the value of the $40 strike price for any given expiration month.
Take this thought one step further. When the option is above the price of the stock, the greater the difference between the strike price and the trading price of the stock, the lower the premium, or value of the option. This only makes sense. If a stock is trading at $38.00, a $40 option will always have more 'expectational' value than a $50 option with the same expiration. This is because the odds (probability) of a stock moving from $38 to $40 are greater than the same stock moving from $38 to $50 over the same time period. If reinforcement of this fact is needed, look at any option chain for any stock and any expiration. You will never find a case where a higher strike price has greater value than a lower strike price, so long as the expiration month is the same.
What is the significance of all this information? If there are strike prices between the current trading price and the existing covered call option, it is possible to Buy Back the existing option and sell a Lower strike price option with a net cash gain in the portfolio. By lowering the strike price, the covered writer is attempting to capture additional premium over the same time period.
CAUTION: A covered writer must understand that when the strike price is lowered, the probability of the stock moving above the new strike price is increased. If that happens, and the result of the option being exercised would result in a loss, then action would need to be taken in order to prevent the stock from being called. Initial Positions are established based on the SysCW Math Exercise which provides information about the back-to-cash gain if the option is exercised. If the strike price is lowered . . . the back-to-cash position would be lowered also.
Investing is serious business. When contemplating using the BB&Lower strategy of Systematic Covered Writing, one needs to ask themselves - "Do I feel lucky". Sometimes the Buy Back & Lower will work and extra cash will have been generated over the same time period, and sometimes it won't work. If the stock moves above the new lowered strike, the BB&RO or BB&RO&Up strategy will be needed to protect the position. So, there is a plan if the writer is wrong (surprise ... surprise)! Note that if this is the case, the covered writer would have been better off leaving the existing position in place.
So . . . do you feel lucky?
SYSTEMATIC COVERED WRITING
Copyright © 2006. All rights reserved.
Revised:
04/17/11