Screening for Buy/Write Candidates

December 17, 2012

Randy Frederick
Managing Director of Trading and Derivatives, Schwab Center for Financial Research

I've written many articles and taught many seminars about the potential benefits of the buy/write or covered call strategy and the one question that I'm asked most often is, "How do I find good candidates?" Like many investing-related questions, there's no single right answer. However, this article will cover the four-step process I've used for many years, which might make your search for quality candidates a little easier.

Step 1: Assess the market

The first step in searching for good buy/write candidates is to assess the overall market. When you read about the fundamentals of buy/writes, you'll often hear that the ideal market is one that is neutral to slightly bullish. That doesn't mean that the strategy can't be profitable in a slightly bearish market or an extremely bullish market, but it's typically a little more difficult under those circumstances. Regardless of the market environment, it's important to take a look at market volatility. The most common method for gauging market volatility is the level of the CBOE Volatility Index or VIX. While the VIX measures implied volatility on the S&P 500, it's generally considered a proxy for market volatility overall.

Moderately bearish market

To help improve your chances of trading buy/writes profitably during a moderately bearish market, it's important that the volatility be relatively high from a historical perspective, and you should consider moving the strike price of your call option lower so that it's in the money. When volatility is relatively high, options prices will be relatively expensive and lower strike price call options are always more expensive than at-the-money or out-of-the-money options on the same stock. Both of these factors will increase the option premium you receive when you enter your buy/write during a moderately bearish market.

If you are assigned on your in-the-money buy/write, you will incur a loss on the stock leg of the strategy but, if executed correctly, the option leg of the strategy should be enough to make the strategy profitable as a whole. Additionally, the high price of the option leg provides more downside hedge than the price of an at-the-money or out-of-the-money option. During a bearish market, downside protection is a very important consideration.

Flat market

To improve your chances of trading buy/writes profitably during a flat market, in which volatility may be average from a historical perspective, you should consider setting the strike price of your call so it is at the money. When volatility is average, options prices will typically be lower than during a bearish market, but at-the-money call options will usually be more expensive than out-of-the-money call options. This will slightly increase the option premium you receive when you enter your buy/write during a flat market.

If you are assigned on your at the money buy/write, you will pretty much breakeven on the stock leg of the strategy, but the option leg of the strategy should be enough to make the strategy profitable as a whole. Additionally, the higher price of the option leg provides more downside hedge than the price of an out-of-the-money option. During a flat market, downside protection is also an important consideration.

Bullish market

To maximize your profitability during a bullish market, in which volatility may be below average from a historical perspective, you should consider setting the strike price of your call so it's out of the money. When volatility is below average, options prices will typically be lower than during a flat or bearish market, but out-of-the-money call options will allow for more upside appreciation in the stock than in-the-money or at-the-money call options. If you are assigned on your out-of-the-money buy/write, you will typically be profitable on the stock leg of the strategy, and slightly profitable on the option leg of the strategy. While the lower price of the option provides very little downside hedge, that is usually not as big a consideration during a bullish market .

Take a look at the table below, which shows a hypothetical example of how different strike prices and volatilities could affect buy/writes under various market conditions:

Buy/Writes in Bullish, Flat and Bearish Markets

Notice that during a bullish market, you would typically structure your buy/write so the strike price of the call option is out of the money. In this example, the stock is trading at $35.05 and a proposed strike price for the call might be $37. While the implied volatility is relatively low (47%), this trade has a maximum profit of 10.6% but only provides downside protection of 5.0%. If assigned, the stock will be sold at $37 (a gain of $1.95 per share), plus the option premium of $1.75 would be retained for a net profit of $370 per 100 shares. Since downside protection is not of great concern, this strategy has only $1.75 of downside hedge.

During a flat market, you would typically structure your buy/write so the strike price of the call option is at the money. In the example above, the stock is trading at $35.05 and a proposed strike price for the call might be $35. While the implied volatility is slightly higher (55%), this trade has a maximum profit of 8.3% but also provides downside protection of 8.4%. If assigned, the stock will be sold at $35 (a loss of $.05 per share), but the option premium of $2.95 would be retained for a net profit of $290 per 100 shares. Since downside protection is of moderate concern, this strategy has $2.95 of downside hedge.

During a slightly bearish market, you would typically structure your buy/write so the strike price of the call option is in the money. In our example, the stock is trading at $35.05 and a proposed strike price for the call might be $33. Because the implied volatility is even higher (63%), this trade has a maximum profit of only 6.7% but provides downside protection of 12.6%. If assigned, the stock will be sold at $33 (a loss of $2.05 per share), but the option premium of $4.40 would be retained for a net profit of $235 per 100 shares. Since downside protection is of great concern, this strategy has $4.40 of downside hedge.

Step 2: Look for candidates

Now that you've assessed the mood of the overall market, the next step in helping identify good buy/write candidates is to create a screener to help find the right stocks or ETFs. A good way to do this is to use Schwab's Customizable Options Screener. Since this tool is designed to meet the needs of option traders of all levels, it can be a bit overwhelming if you've never used it. I'll show you how to focus on only those parameters that are most important to buy/writes.

Underlying price

Since each buy/write involves the purchase of at least 100 shares of stock, the first setting in the screener is to define the stock price range in which you are willing to trade. It doesn't make sense for the screener to suggest buy/writes on stocks that are $200 or $300 per share, if you wouldn't normally buy stocks that are that expensive. Likewise, if you consider low-priced stocks to be too speculative, adjust the screener so it skips stocks below $5 per share (or a similar low threshold).

Average volume

In my opinion, you should avoid low-volume stocks because illiquid stocks are likely to have illiquid options. Consider setting the minimum average daily volume to at least 100,000 shares.

Implied volatility

Options on stocks whose implied volatility is too high will be excessively risky and generally not worth the modest profits that might be generated from a buy/write strategy. Consider setting this parameter to a maximum implied volatility of 50% in low volatility markets. In high volatility markets, you may want to consider 75% or higher.

Static rate of return

One of the two most important measures of the merit of any buy/write is how much profit you'll earn if the market goes sideways. Here are some guidelines to consider:

Also, keep in mind that, for at-the-money or out-of-the-money buy/writes, the static rate of return is also the amount of downside hedge you'll have if the stock moves against you. For in-the-money buy/writes, your downside hedge will exceed the static rate of the return.

Assigned rate of return

The other key measure of the merit of any buy/write is how much profit you'll earn if the market goes up. Since a buy/write is a bullish strategy, you generally only want to use it on stocks that you think will be going up. Below are some guidelines to consider in setting this parameter:

In a relatively low-volatility environment, you may need to use the lower end of these ranges. In a higher-volatility environment, the upper end will be possible. Assigned rate of return is also the maximum profit you can earn on a buy/write, since the maximum profit is earned when you are assigned.

Once you have created an Option Screener that has the settings you want (as in the example below), be sure to name it and save it for future use.

Source: schwab.com.

Step 3: Check the ratings

When you get your output list from the screener using the process listed above, there are two additional things you should consider checking before you enter any orders— the Schwab Equity Rating (SER) and the Market Edge Second Opinion® Weekly (MESOW) Rating. I suggest only trading buy/writes on stocks with a Schwab Equity Rating of "A" or "B" and a MESOW rating of "Long" with a Score of "0" or "-1". Both of these Ratings are available by clicking on the stock symbol from the output list of your screener. Along with the rating, I suggest that you read the accompanying Schwab Equity Rating Report, which provides detailed information to consider and can help you understand the factors that determine the rating.

Reference to any securities mentioned above is provided as an example for illustrative purposes only.

Source: schwab.com

Step 4: Order entry

Similar to single-leg options or stock orders, buy/writes have both a bid and an ask price, and you usually don't have to pay the market asking price for execution. As you would on a single-leg order, consider entering a limit order between the bid and ask price. When you look at a multi-leg order like a buy/write on any of our trading platforms, the bid and ask price will appear across from each other, but the bid will be on the right and the ask will be on the left. To help maximize your chances of getting an execution, but at a favorable price, consider entering the order slightly on the high side of the midpoint. In the example below, 204.34–204.36 could be an appropriate limit price.

Source: schwab.com.

Once your order is executed, the goal is typically to hold it until expiration. However, if the stock moves higher or lower faster than you expect it to, you will generally have the ability to close it out in the market at any time prior to expiration. The most efficient way to do this is at a single net credit through a transaction called an "unwind." This order is entered on the credit side of the screen shown above.

Good luck and good trading.