Buy/Write Combos Let You Bag Some Big Bucks With Little Risk

Few investors ever take the time to understand buy/write combination plays. That's a shame, because they offer chances for huge percentage gains on relatively small initial cash outlays. In addition, they provide margins of safety vs. outright purchase of shares, often allowing moderate declines in the underlying stocks to still produce profitable trades. What are buy/writes? They typically involve buying round lots (100-shares or any multiple of 100) of a favored stock, while shorting covered calls as well as naked puts. I usually employ identical expiration dates and the same strike price although that is not a requirement. Low-priced stocks are especially well-suited for this technique as the option premiums represent very large percentages of the actual cost to buy the shares. Selling both puts and calls on the same security, for the same expiration day, ensures that at least one of the option buyers has to be wrong. Upon expiration, if the underlying shares close above the strike price selected, they cannot also be below that number. If they close below the strike, they cannot be above it. The key to success begins with selecting an underlying stock, which you believe will trend higher, or at least not decline significantly, from the trade inception date through its expiration. Here are two examples to illustrate the exciting upside when using buy/write combinations. Coty is a multi-billion sales company and a leader in its field. Its shares were pummeled in the Covid-19 plunge, dropping from $13 this past February to just below $5 on Wednesday trading. Independent research house Morningstar labels COTY as a 4-star buy. It calls present-day fair value as $6.50. Yahoo Finance is a bit less optimistic on COTY but does hold out a $5.88 target price for the stock by this time next year. Whichever view you buy into, it appears likely that COTY can regain and hold the $5 market again through Jan. 15, 2021. That would only require a 1% - 2% gain over the coming 212 days. Here are the actual numbers on a 1,000-share, 10-call and 10-put buy/write to that expiration day. If executed in a margin account with adequate free buying power the net cash outlay would drop to just $1,440 on the entire combination. There are just two possible outcomes for this trade if held through expiration. COTY will either close at $5, or higher, or below $5. If COTY fails to hold at the $5 minimum price required to achieve those results, you'd be required to buy another 1,000 shares while laying out an additional $5,000. Total cost for the entire 2,000-shares held, though, would be just $6,440. That's just a $3.22 per share average cost. COTY could decline by up to $1.69 per share, or 34.4% of the $4.91 trade inception price without causing a loss on the full buy/write combination. That's a fine extra margin of safety. As a reference, COTY's momentary absolute low in the March panic was $3.02. It closed at $3.74 that same day and never revisited sub-$3.22 ever again. On a closing price basis, owning COTY at the $3.22 worst-case average price would have been a winning position 100% of the time since its June 12, 2013 initial public offering. Fashion designer Vera Bradley is another low-priced stock offering terrific risk/reward for buy/write combinations. Morningstar assigns VRA its highest, 5-star buy rating. They see VRA's present-day fair value as $8.18 per share. On Monday, Jun. 8th VRA hit an intraday peak of $7.65. As of Wednesday trading, though, we could buy it for under $5.50. Vera Bradley topped out for $11.90 or higher each and every year since 2013, including 2020 year-to-date. Yahoo Finance sees VRA earning $0.77 in fiscal 2021, which ends Jan. 31, 2022, putting its ultimate price-to-earnings at just 7.0-times that year's estimate. Yahoo's 12-month target price for VRA now sits at $10 per share. VRA does not have long-term options available. Right now the longest expiration, which trades, is for Nov. 20, 156-days away. On Monday, it will begin offering Feb. 19, 2021 expirations. It seems a good bet that VRA will close at $5, or better, on Nov. 20. The table below shows pricing for Nov. 20, 2020 expirations on the share, plus its $5 calls and puts. There are just two possible outcomes for this trade if held through expiration. VRA will either close at $5, or higher, or below $5. If VRA fails to hold at the $5 minimum price required to achieve those results, you'd be required to buy an additional 1,000 shares while laying out an additional $5,000. Total cost for the entire 2,000-shares held, though, would be just $7,950. That's just a $3.975 per share average cost. VRA could decline by up to $1.47 per share, or 27% of the $5.45 trade inception price without causing a loss on the full buy/write combination. That's a fine extra margin of safety. Vera Bradley hasn't traded below the $3.975 break-even price on the full buy/write combination described since April 6, 2020. Future stock market action can never be guaranteed. These type of trades, though, offer outstanding prospects for large gains while protecting against all but the most severe sell-offs.

Buy/Write Combos Let You Bag Some Big Bucks With Little Risk

Here we look at the benefits of putting down small cash in buy/write strategies for Coty and Vera Bradley.

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