BuyBack & Lower Strategy

Please note … this is a long explanation. The ending should make the reading worthwhile! Some will ‘get it’ the first time through, while others will have to go through the information more than once. Some movies are like that …

This strategy was first used in the summer of 2009. The SysCW process includes an ongoing evolution in an effort to provide solutions for various covered call situations. There are plenty of Web sites where one can find good Initial Positions. When they work ... GREAT ... but sometimes things happen. One of the goals of Systematic Covered Writing is figure out the best thing to do when 'stuff happens'. To that end ... consider this situation.

There will be times when a stock loses a significant amount of value. Trust in the fact this is almost inevitable! In the past, the main SysCW strategy has been to write Interim Trade calls, and or to Dollar Cost Average ($CA) the position. At times it was necessary to use the Como Buy Back & Roll Out & Up strategy. One of the downsides to a strategy that involves Dollar Cost Averaging lays in the fact further depreciation of the underlying stock may occur. Given enough time, more often than not, the $CA strategy will still work. It’s just there are times when a writer may wish they had waited to make the second purchase. It is from this perspective that the SysCW Protective Stop strategy was conceived.

Let's look at an example and use it to explain the Buy Stop Strategy. For this example we will use a Corinthian Colleges Inc. (COCO) position that had lost so much value the BB&Lower strategy was used. The COCO shares were purchased in April 2010. The Initial Call Option was the ’11 Jan $15 LEAP, which was sold for $2.90 a share. In October, this call could be purchased for a nickel!

Remember from the discussion of the BB&Lower strategy that expiration for the replacement option needed to be no longer than the option it was replacing. The new call can have a shorter duration … just not longer. As you can see in the Position Tracker data, the ’11 Jan $15 call was closed with a cost of $13.25 and a Nov $5 call was sold generating $36.74. The amount received for the new call option was greater than the cost for the closed option, which satisfied the other rule for the BB&Lower strategy.

				SysCW Position Tracker
Historical Data				ACTIVE Position
	Stock				Stock	Cash	Total Cash	Value As of
Date	Price	Strategy	Status	Position	Investment	Generated	Generated	15-Oct-10
30-Apr-10	$15.77	Initial Stock Purchase		Buy 100 COCO @ 15.7699	($1,583.99)			$431.00
		Current Price	$4.31	Corinthian Colleges Inc
30-Apr-10	$15.77	Initial Call Option		Sell '11Jan $15 LEAP @ 2.90	Lowered 10/15/10	$281.74
15-Oct-10	$4.78	Buy Back & Lower		Buy Jan $15 call @ .05		($13.25)
15-Oct-10	$4.78	Interim Trade		Sell Nov $5 call @ .45		$36.74

		Cash in Hand	19.27%				$305.23

The price of COCO was still below $5 when the Nov $5 call expired. As far as the BB&Lower strategy is concerned … it worked, but there is more to come. On 24-Nov-10 COCO was trading at $4.55. The premiums for call options were very low, as was the stock’s price!

At the time, it was apparent that another interim call was going to be sold. The thinking for Recover After Expiration call option in this situation would be as follows:

· Select a strike price as far as possible above the depressed trading price of the stock.

As has been discussed, these are conflicting guidelines. This is because the higher the strike price, the lower the premium for a given call against the same stock.

STRATEGY PREMISE ... Especially with low priced stocks ... like this COCO position when it was trading below $5, there will be times when a covered writer has no logical call to sell. This is due to the lack of premium. If a call were to be sold, he or she is forced to sell a call with a strike price very close to the current trading price. As stated above, Dollar Cost Averaging a depressed stock is a powerful strategy. It is one that will continue to be used for a variety of reasons. The only negative issue comes in to play when the stock continues to lose value after the additional shares were purchased.

The Protective Stop Strategy attempts to maximize the effectiveness of the Dollar Cost Averaging thought process. Here is how the strategy works:

1. First, we go ahead and sell an interim call against the existing shares. We want the duration for this call to be as short as possible, while still generating a reasonable premium. Remember … the ideal interim call option is one that expires worthless! The longer the duration, the higher the probability a stock could move above the call’s strike price.

The dilemma arises when the stock moves above our strike price ... especially if we are not monitoring a position, which can happen. It's not like we want to be glued to a PC screen during market hours. When a stock moves above an interim call’s strike price, we can become 'stuck' as it could cost more to close an existing option than can be generated when selling its replacement. At times, the Combo Buy Back & Roll Out & Up strategy is used as a way 'out' of this situation.

The bummer here is the Dollar Cost Averaging aspect of the Combo $CA strategy has the writer purchasing additional shares at a higher price than when the interim call was sold. Obviously, one solution is to just Dollar Cost Average the position when an existing option expires. For example, when the ’10 Nov call expired worthless, the writer could have purchased 100 additional shares, and then sold two calls going forward. Once again, we want to avoid if possible for two reasons.

· First, if the stock continues to lose value, the writer would wish he or she had held off on the second purchase. Not that we can ‘time the market’, but if the stake in a given company is going to be increased, why not do it at the lowest possible price?

· The other reason for limiting purchasing additional shares of the same stock comes from a desire to maintain as much diversification as possible. This thought would come more into play if the current price of a stock was significantly higher than COCO was trading at the time.

2. In addition to selling the new interim call, the writer also places a Buy Stop order to purchase additional shares of the stock at a price higher than the current trading price. The idea being ... the writer is willing to purchased additional shares ONLY if the stock moves higher than it is currently trading. This ‘make the stock move in the right direction first’ idea seems better than just buying the shares and 'hoping' for the stock appreciates.

The writer will be Dollar Cost Averaging at a slightly higher price than the day the Buy Stop order is placed, but at the same time, there will be an increased the chance of having the additional purchase being 'worthwhile'. Let's look at the actual activity as the ‘Buy Stop’ order is explained.

				SysCW Position Tracker
Historical Data				ACTIVE Position
	Stock				Stock	Cash	Total Cash	Value As of
Date	Price	Strategy	Status	Position	Investment	Generated	Generated	24-Nov-10
30-Apr-10	$15.77	Initial Stock Purchase		Buy 100 COCO @ 15.7699	($1,583.99)			$431.00
		Current Price	$4.31	Corinthian Colleges Inc
30-Apr-10	$15.77	Initial Call Option		Sell '11Jan $15 LEAP @ 2.90	Lowered 10/15/10	$281.74
15-Oct-10	$4.78	Buy Back & Lower		Buy Jan $15 call @ .05		($13.25)
15-Oct-10	$4.78	Interim Trade		Sell Nov $5 call @ .45	Expired 11/20/10	$36.74
24-Nov-10	$4.55	Interim Trade		Sell Jan $5.50 call @ .20		$11.74

		Cash in Hand	20.01%	BS GTC 100 COCO @ $5.13			$316.97

Before continuing the Buy Stop strategy discussion, let’s back track a little and finish the BB&Lower discuss as it relates to this example … remember we closed a 2011 option when the BB&Lower strategy was used. We then sold a shorter term call which expired worthless. Now another call is being sold with the same expiration month as the original ’11 Jan $15 option.

We use the BB&Lower strategy to increase the amount of cash generated per unit of time. So … in this case the writer spent $13.25 to close the Jan$15, the sold a Nov $5 call generating $36.74. This call expired and is now being replaced with the Jan $5.50 call generating and additional $11.74. This means the net affect of the $CA strategy with this position is a gain of $35.23.

Using the Buy Stop strategy requires two transactions. One is executed, and one is a pending order.

Step One – The interim call option is sold. In this example, the writer sold ’11 Jan $5.50 call for twenty-cents. A clear indication that from the SysCW perspective, every penny counts!

Step TWO – A pending Buy Stop (BS) order is placed with a LIMIT price that is above the current trading price of the stock. The order is ‘pending’ because it is conditional. Technically, it is called a ‘Buy Stop Limit’ order. In this example, as noted in the Position Tracker on the last line above, the Limit price was $5.13.

In words this BS order says the writer wants to purchase 100 shares of COCO, but only if the price of COCO reaches $5.13! …If we just placed this Limit order, it would be in play for one day. At the end of the trading day, if the Limit price had not been reached, the order would just ‘go away’. Notice in the last line in the Position Tracker, there is also a ‘GTC’ written. GTC means Good Til Cancelled!

To make it clear, the BS GTC 100 COCO @ $5.13 notation means we placed a Good Til Cancelled Buy Stop Limit order for 100 shares of COCO at $5.13. By placing the order this way, the writer is saying he or she wants to purchase 100 shares of COCO if the price reaches $5.13, and by the way … keep this order in place until it is cancelled.

The main reason for using this strategy comes from attempting to avoid purchasing stock that is still going to trade lower. In the investment community, this is referred to as ‘don’t try to catch a falling knife’!

To understand its usefulness, this example is going to be continued ‘hypnotically’. Let’s say COCO begins to appreciate. When it reaches $5.13 a share, the Buy Stop Limit order will be executed. What will the position look like at that point?

· There will be the 100 shares of COCO stock with a purchase price of $15.7699.

· There will one contract of a ‘Jan $5.50 call option that was sold for $0.20.

· There will also be an additional 100 shares of COCO with a purchase price of $5.13.

Here comes the interesting aspect of the Buy Stop Strategy. Let’s say COCO continues to appreciate. Needless to say, it has a long way to go before it reaches the original purchase price. When the January expiration arrives, 100 shares of COCO are going to be sold for $5.50 a share. Like magic, this strategy has provided protection for the original shares because the writer is going to ‘give’ the ’11 Jan $5.50 call to the shares that were purchased for $5.13!

It won’t be a profit worth writing home about, but going forward, the position will be able to sell a high priced option against the original shares. One could call this situation a position within a position. In the end, the writer was able to use an interim call option without the fear of it creating a loss.

				SysCW Position Tracker
Historical Data				ACTIVE Position
	Stock				Stock	Cash	Total Cash	Value As of
Date	Price	Strategy	Status	Position	Investment	Generated	Generated	24-Nov-10
30-Apr-10	$15.77	Initial Stock Purchase		Buy 100 COCO @ 15.7699	($1,583.99)			$431.00
		Current Price	$4.31	Corinthian Colleges Inc
30-Apr-10	$15.77	Initial Call Option		Sell ‘11Jan $15 LEAP @ 2.90	Lowered 10/15/10	$281.74
15-Oct-10	$4.78	Buy Back & Lower		Buy Jan $15 call @ .05		($13.25)
15-Oct-10	$4.78	Interim Trade		Sell Nov $5 call @ .45	Expired 11/20/10	$36.74
24-Nov-10	$4.55	Interim Trade		Sell Jan $5.50 call @ .20		$11.74

		Cash in Hand	20.01%	BS GTC 100 COCO @ $5.13			$316.97

So what happens if some other scenario takes place? Part of the philosophy of SysCW lays in a realization of what CAN happen, and knowing what will be done whenever a ‘can’ becomes a reality. With the Buy Stop strategy, there are other plausible outcomes.

If the stock does not appreciate, the Buy Stop Order will not be executed. This would be like having insurance without ever paying for it. Another possibility would be for the stock to reach $5.13, but not $5.50 by the time the call expires. In this case, the second purchase would be treated as a normal Dollar Cost Averaging purchase, which happens to be a component other SysCW strategies. The writer would just trade the position forward from there.