The Specifics of the Buy-Write Transaction
* We purchased 500 shares of Wells Fargo & Company common stock at $15.12 per share for a total of $7,572.95.
* We then immediately sold 5 call contracts (covering 500 shares) on those shares, giving another investor the right, but not the obligation, to purchase them from us at $14.00 each any time before the expiration of May 16th, 2009 in exchange for an insurance premium of $3.30 per share, or $1,646.24.
The Analysis of This Transaction:
This would have created an immediate loss between the purchase price and the lower strike price ($15.12 - $14.00 = $1.12 loss) except that we were paid $3.30 in premiums for entering into the transaction, or $1,646.24 for all five contracts. Thus, if the options were exercised (which is highly probable given that they are below the current market price and thus "in-the-money" with an expiration of approximately 43 days hence), we would have an immediate net gain of $2.18 (the $3.30 premium we were paid - $1.12 built-in exercise loss). This makes our effective cost basis on the shares only $11.82. We will also receive any dividends on the stock during our holding period, providing additional income.
Let's look at how the position will work out for us under three different scenarios:
Scenario 1: The stock remains above $14 per share by the time the options expire, virtually guaranteeing they will be executed ("assigned") to us.
In this case, we will have a built-in gain of $2.18 per share for our 500 shares, for a total of $1,090 before commissions. The cost to us was tying up a net $5,926.71 for 43 days, generating an 18.39% return in that same period. The compound annual growth rate on an annualized basis greatly exceeds 150% if we could find comparable investments to this and continue to write them, something that won't happen once the panic in the banking sector has ended.
Scenario 2: The stock falls below $14 per share by the time the options expire, meaning they are not executed ("assigned") to us.
In this case, we still own the 500 shares of Wells Fargo & Company outright with an adjusted net cost basis of $11.82 per share. Anything above that amount is a gain. We would also be able to immediately turn around and write another set of call options against our stock, generating another $2 to $3 in premiums, lowering our cost basis even further. Either way, our risk is much lower than if we had simply bought the stock outright because we have the downside cushion of $11.82 per share instead of the current market price of $15.12, which would have been our cost basis in a plain-vanilla stock purchase.
Scenario 3: The stock goes to $2 or less due to the banking panic, following in the footsteps of Wachovia, Washington Mutual, AIG, Bear Sterns, Citigroup, etc.
We are still better off than we would have been in a plain vanilla stock purchase because we only had to tie up $11.82 per share in our capital to buy the 500 shares of Wells Fargo & Company common stock. In other words, had we simply bought the shares outright, it would have required $7,572.95 of our company's money. Instead, we used the call premiums of $1,646.24 to offset this amount, meaning that only $5,926.71 of our money was tied up for the same economic level of ownership.
