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I've missed a few reccs over the years due to life's many interrupts. When I finally get to catching up, I find that the stock has run away a bit. ORLY is one example for me.

What about initiating these positions as covered calls with a buy/write?

My reasoning goes like this:
- you want, or wanted, the position anyhow
- valuation is higher than you want
- if the stock gets called away, you accept that along with the income, as a highly valued stock being sold.
- depending up on strikes chosen, you can reduce cost basis in the shares.
- choose higher strikes to nip away at cost basis, or lower strikes nearer fair value to possibly make more income, rolling calls when necessary

There are certainly risks here if the stock tanks 20% and you only collected 4% premium, but that would be a similar story if it was a long in you portfolio anyhow. Choosing a strike 10-15% below current price could provide some cushion there.

Any comments? Anyone done this?

Frank
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There are a number of ways to handle this situation. I look forward to other's thoughts. I'm not sure what is better. I'd love a table of what strategy is better in what case.

I think the covered call strategy is probably a good one if you think the stock is pretty fully valued/extended.  I generally step in in parts. 1/2 position, etc.

If you think there is likely good upside from here and don't want to limit the appreciation then I might be more inclined to just buy a 1/2 position of the stock and sell  puts for the other 1/2 to lower the cost basis or potentially fill the position at a lower price.

Or, you could sell a put at a lower price to finance the purchase price of a call. The time value in the put offsets the time value in the call and the premium you get pays for the call. So worst case, your call expires worthless and you are forced to buy the stock at a the strike price. But, you don't lose any money unless the stock is below the strike of the sold put. And you get to keep the upside.

Just some thoughts. Not recommendations.

Connie

 

 

 

 

 
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Hi Frank,

Connie made some very good points.

My strategy is that I purchase some shares to get some skin in the game. Often I have seen the stock take off, and had I never purchased the partial allocation, I would have never gotten shares. This also limits the risk if the stock should drop. Recently I purchased a partial position in PRXL (slightly above the recommended limit), and have been trying to get the remainder of my shares via puts. The way PRXL is running, it may never happen, but then I have the income from the puts, and I have a partial allocation.

As for writing in the money calls, these are really the same (almost) as writing puts. I would generally write puts about 3 months out to get the remainder of my allocation. This method does not always work because of the individual stock price may make the allocation too large. ORLY may be one such stock depending on the size of your portfolio.

A long time ago I was having problems getting my broker to allow writing puts in my IRA, so I was doing in the money calls. But I prefer to write puts.

Hope this helps,
Mike
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I guess I forgot to mention at first that using puts to enter positions is not my fave. I use them for income, or as part of synthetic long, but that's about it. Also, I'm trying to pay more attn to valuation, given the past year performance.
For ORLY, PRO pegs a 118 fair value estimate. Morningstar says 110. Both are estimates, but you need to base a decision on some metric of value. Let's call this one 114 for the average between them.
At a 131 current price for ORLY, there is no margin of safety off a 114 FV.
So that's the rationale for the covered call vs. written put.

Frank
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Hi Frank,

I would argue that writing a put is the same as a covered call.

For example for ORLY: priced at $132.29

Using the May 2014 $115 covered call as compared to the written put:

                Covered Call        Cash Secured Put
Option value:     $   18.80         $   1.50
Commission:            2.00 (IB)        1.00
Exercise Fee           0.00 (IB)        0.00
Time value of Option:  1.51             1.50
Expected Dividend      0.00

If stock closes above $115 - the call will be exercised

Option Payment: $   1,880.00         $   150.00
Stock Cost:        13,229.00               0.00
Commission:            -2.00              -1.00
Net Income:       -11,351.00             149.00
Exercise Payment:  11,500.00               0.00
Exercise Fee:           0.00               0.00
Total Income:         149.00             149.00

If stock closes below $115 - the put will be exercised

Option Payment: $   1,880.00         $   150.00
Stock Cost:        13,229.00               0.00
Commission:            -2.00              -1.00
Net Income:       -11,351.00             149.00
Exercise Payment:       0.00          11,500.00
Exercise Fee:           0.00               0.00
Total Cost:       -11,351.00         -11,351.00
Net Purchase Price:   113.51             113.51

Depending on your commissions paid, exercise fees involved, 
dividends, and the option pricing achieved, the answer 
will vary slightly.

Overall, really the same thing,
Mike
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Frank,

So that's the rationale for the covered call vs. written put.

Mike (SilverHawk) is exactly right. Covered call and written put, provided you are looking at the same strike price and expiration for each, are the exact same thing. This is one of the most fundamental truisms of options trading, and the market essentially requires it to be true. When this behavior (known as put/call parity) breaks down even a little bit, the market quickly closes it since it is an arbitrage situation (read: free money) if it persists for any length of time.

There are differences between written puts and covered calls but they are very subtle and not related to the risk/reward. For example, you might pay less commissions with one or the other, depending on your broker. You might prefer one for tax reasons. You might prefer the way one or the other looks in your account window. You might like to use the free loan known as buying power to write puts that extend your account beyond 100% without paying margin interest. Those are all reasons to prefer one to the other but they don't change your returns or your capital at risk.

There is a good thread on put/call parity over on MFO:
http://boards.fool.com/1321/not-a-good-look-31089233.aspx?so...

Realize there are a few people in that thread who are confused on the topic. To cut to the chase, pay careful attention to Jim Gillies' posts, and ignore any contrary posts. The algebraic explanation of put/call parity is interesting and useful too.

Rob
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"thanks" for the link to that MFO thread, Rob.   That was painful.  Reminded me of a conference call I had a day or 2 ago. 

I've been a PRO member since day 1, or at least by day 30, so I get the math of it all.  

It is some of the subtle points that I was looking for here: 

"There are differences between written puts and covered calls but they are very subtle and not related to the risk/reward. For example, you might pay less commissions with one or the other, depending on your broker. You might prefer one for tax reasons. You might prefer the way one or the other looks in your account window. You might like to use the free loan known as buying power to write puts that extend your account beyond 100% without paying margin interest. Those are all reasons to prefer one to the other but they don't change your returns or your capital at risk."


Another difference is ownership, but that too could be argued based upon valuation.  If you're writing covered calls, it could then be considered an income position or sell.   If you write an at/near the money option (put or call), and the stock plunges, then is it better to be PUT a falling knife or owning one?  

thanks for the comments,

Frank

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Perhaps the answer here is to take out the emotion and rely on discipline and numbers. Theoretically, this shouldn't be too hard for this engineer to understand :-)
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Hi Frank,

If you write an at/near the money option (put or call), and the stock plunges, then is it better to be PUT a falling knife or owning one?

The only difference that I can see is that owning the shares and writing calls has you at or closer to a long term gain or loss than acquiring via puts. If you really have a long term view, it doesn't matter at all.

Regards,

Lon.
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Hi Frank,

Another difference is ownership, but that too could be argued based upon valuation. If you're writing covered calls, it could then be considered an income position or sell. If you write an at/near the money option (put or call), and the stock plunges, then is it better to be PUT a falling knife or owning one?

As Lon says, it doesn't matter. More to the point, it won't make a dollar of difference to your account balance. If a covered call position results in you losing $X, then the equivalent written put position will also result in you losing that same $X.

The biggest point of concern with put writing, when compared with covered call writing, is that Pro/MFO steer you towards getting a margin account, but in a margin account you can write puts that expose you to more than 100% of your cash balance. Compounding that problem is the way brokerages report the information to you, which tends to hide your actual exposure.

I have addressed this issue by keeping an ongoing spreadsheet of all my put writes. It allows me to quickly compare my put-writing commitments to my cash balance without the need for mental gymnastics. If I weren't using this spreadsheet crutch, I'd prefer covered calls simply to keep me straight on my commitments. Using a cash account is another easy way to keep yourself from going beyond 100% (assuming that is a goal).

Rob
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Hi Rob,

The biggest point of concern with put writing, when compared with covered call writing, is that Pro/MFO steer you towards getting a margin account, but in a margin account you can write puts that expose you to more than 100% of your cash balance. Compounding that problem is the way brokerages report the information to you, which tends to hide your actual exposure.

I have addressed this issue by keeping an ongoing spreadsheet of all my put writes. It allows me to quickly compare my put-writing commitments to my cash balance without the need for mental gymnastics. If I weren't using this spreadsheet crutch, I'd prefer covered calls simply to keep me straight on my commitments.


Those words of wisdom easily merited the rec and the repetition. Keeping track of one's commitments is always important (puts or otherwise). Like you, I maintain a spreadsheet that shows my put obligations, both total and monthly breakdown. It is part of my morning ritual to review that before placing any limit orders.

Really good advice!

Lon.
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