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Buy-Write Is Buy Wrong


To recommend this strategy without warning of its risks is malpractice. Period.

Someone I know recently asked his financial advisor to recommend some reasonably safe places to put cash from maturing certificates of deposit.

He received several ideas, one of which was to do a buy-write (covered call) on a controversial company known to the general public for its industrial businesses, but subject to a great deal of market concern, owing to its financial-services unit.

The security selection troubled me enough. Of far greater concern, though, was the advisor's description of the strategy: "The greatest risk is that the stock goes from 10 to 20, so that you will end up selling the stock (via the written call option) at a price much lower than 20."

This is frightening, folks. This is flunk-your-Series-7 stuff. This is malpractice.

For those who haven't spent much time with options, covered-call writing is probably the most common strategy. It involves buying a stock and selling a call against it, generally with an exercise (strike) price slightly above where the stock is currently trading.

It's a perfectly reasonable strategy when you like a stock, but aren't head-over-heels in love with it. You'd be glad to make a profit of 10-30% in a matter of months, and you're willing to forgo in case the stock really flies.

But you still have virtually all the downside exposure to a big fall in the stock, lessened only by the amount of the call option you sell.

Here's a huge irony in this:

The single biggest focus in the entire financial catastrophe is the bailout of American International Group (AIG). Why did we bail out AIG? Because it sold too many credit default swaps with impunity. It bet too freely that things wouldn't go down. It pretended, essentially, that things couldn't go down. Of course, they did.

Credit default swaps are essentially put options on credit. AIG sold put options on credit. There's nothing wrong with doing that, if you price the options right and have the financial strength to withstand losses. AIG came up short on both counts.

But here's where the irony kicks in. Selling puts -- like AIG did, in the form of credit default swaps -- is economically identical to buy-writes, covered calls, whatever name you prefer. The economics are: Win modestly if the underlying asset goes up (no matter how much it goes up), potentially lose massively if it goes into the tank.

So here's this financial advisor of someone I know saying that the big risk of doing a buy-write is that the underlying stock might double. No mention of the potential losses on the downside.

This is why I joined the 'Ville - to fight for financial literacy.

Because this stuff is scary.

In memory of our fallen friend and trusted colleague, Bennet Sedacca, 100% of the donations made to the RP Foundation through April will be channeled to philanthropic endeavors consistent with the RP mission, working closely with the Sedacca clan in the distribution of those funds. We thank you kindly for your support as we strive to effect positive change in the lives of children.
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No positions in stocks mentioned.

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