One of the frequent trades that I do, especially in my Long Term account, is the Buy Write. This trade involves buying the underlying equity position and selling an upside OTM (Out of the Money) Call option against the position.
This trade accomplishes 2 key things:
- Provides some downside protection for the underlying equity
- Although it caps the gain with the sold upside call, it helps to position oneself for a predictable upside gain
A trade I am putting on today is a Buy Write in ANR (Alpha Natural Resources). The trade goes like this:
For each 100 shares purchased of ANR, sell 1 Call contract of the November 21 option for 1.60.
Breaking down the trade, this is what happens. If you put on this trade here, you are buying ANR at 19.75 with downside protection to 18.15 (from the equity buy point). You are capping your gain on the underlying equity at 21 (if excercised).
- You keep the 1.60 in option premium collected on the sold call contract(s)
- If the stock does drift up to the 21 strike by November (and called away) you achieve additional capped upside of 1.25 from this level for a total of 2.85 in upside.
If you prefer more downside protection, but with a tighter cap on equity gains, you can sell the Nov 20 strike Call for 2.10 for protection to 17.65