A buy-write (also called a covered-write) is simply a covered call -- long stock plus a short call (please see our section during week 6 on covered calls for more details). 

The difference in the buy-write is in the way the order is handled.

Most investors who enter covered call positions buy the stock first, then sell the call at a later time.  The problem with delaying the sale of the calls -- even if it's only a matter of seconds -- is that you will be exposed to market movement and downside risk in the interim.

Example:

Say a stock is trading for $100 and a $100 call is trading for $5.

An investor wants to enter into a covered call position.  They feel that effectively paying $95 for the stock and selling it for $100 over the next month will be adequate potential profit relative to the risk they are taking.  So they put in a market order to buy the stock, but get filled at $101 because heavy trading caused the stock to move up.  Then they immediately put in the order to sell the call.  The stock starts to fall and they sell the call for $4-1/2. 

The five-point profit they were seeking has now been reduced to $3-1/2.  They bought stock for $101 and sold the call for $4-1/2 effectively paying $96-1/2 for the stock instead of the desired $95 at the outset.

This is very common for people who enter covered calls in this manner.  This is sometimes called "legging in" to a covered call because each of the "legs" -- the long stock and the short call -- is entered as a separate order.

To prevent this risk, known as execution risk, the above investor could have entered a buy-write.  There are two ways to enter a buy-write order: (1) As a market order (2) As a limit order

If the investor enters the buy-write "at market," this means the entire order -- both the long stock and short call -- must get filled simultaneously and the investor is willing to take the prevailing prices at the time their order arrives to the floor or market makers.  In the above example, had the investor entered a buy-write, they may have paid $101 for the stock but also may have received $5-1/2 for the call for a net debit of $4-1/2.  This is still not the $5 point profit they were expecting, but certainly better than the $3-1/2 they got. 

If the investor enters a buy-write as a "limit order," they will specify the price they want to pay.  The risk here is that the order does not get filled. However, if it does, you know the price will be at your limit or lower.

Example:

Say we see the following quotes:

If the investor were able to get filled at the current prices, this buy-write would fill for a net debit of $95.  This is because the investor can currently buy the stock for $100 (the ask) and sell the call option for $5 (the bid).  This is also called "the natural" quote because a debit of $95 is where the buy-write would be filled naturally if the trade could be executed immediately.

The investor may tell their broker, "I'd like to place the following buy-write: Buy 500 XYZ and sell the Mar $100 calls for a net debit of $95."  Now, the only way the trade can get filled is if the buy-write is filled at this price or lower.

Remember, this is the net debit the investor is willing to pay so the order could come back filled as:

Stock purchased for - $101
Call sold for                + $6
For net debit of            $95

(or any other number of combinations of stock and option prices as long as the net debit does not exceed $95).

If you enter a limit order on a buy-write, it must always be entered as a net debit for the fact that the price of the call can never exceed the price of the stock. (Please see our section on "Basic Option Pricing" during week 5 for more information.) 

Placing a buy-write with the market maker is similar to trading in a car.  If your car is worth $10,000 and you are trading it in on a $25,000 car, you may tell the dealer, "I want to buy that one and sell this one for a net cost of $15,000." 

Now, it should make no difference to you if they charge you $26,000 for the new car as long as they give you $11,000 for your trade.  Or, the dealer may only want to give you $9,000 for your trade, but then must be willing to sell you the new car for $24,000.  You are doing the same thing with the market maker on a buy-write limit order; you are specifying the net difference you are willing to pay for buying the stock and selling the call.

Of course, you may decide to try for a little better deal.  Using the above quotes again, you may see the "natural" is $95, but tell your broker to place the order for a net debit of $94-3/4. 

Regardless, any time you put in a limit order, you may not get filled.  So you need to decide which is more important -- getting filled or getting the price you want.  You can only guarantee the execution or the price, not both.

By the way, if you do enter into a buy-write, you can close it out anytime with a simultaneous order too.  You can tell your broker to sell the stock and buy back the call which is called an unwind.  Unwinds will always be executed for net credits.

Sell-write

Many investors do not know this, but there is a trade opposite the buy-write, which is known as a sell-write.  To enter a sell-write, the investor simultaneously shorts the stock (sells it) and then writes the put.  The resulting position is a covered put; the sell-write is just a method of executing the two trades together to avoid execution risk.

Now, if the stock falls, which is what the investor is betting on, he may be assigned on the short put and be forced to buy the stock.  But this is what the trader desires, as he can profitably cover the short stock position through the assignment of the put.  As with the buy-write, the short option position is considered "covered" because the risk of the short put -- the downside -- is covered by the short stock.  This does not mean this strategy is risk-free; the trader has unlimited liability to the upside.  The short put just provides a little upside hedge.

Example:

A trader is bearish on XYZ trading at $100.  He decides to place a sell-write.  What is the "natural" based on the following quotes?

The natural is $100-3/4 because the trader can currently sell the stock for $95-3/4 and sell the put for $5 for a total credit of $100 3/4.  Notice what the sell-write accomplishes.  The trader now has a higher net credit, which is what you want when you are short-selling.  If the trader were just shorting the stock, he or she would only receive $95-3/4 but instead, with the sell-write, receives $100-3/4.  Remember, when short-selling, you sell high and buy low.  The sell-write gives you a higher credit.

Because of this higher credit, the sell-write provides a little upside hedge for the trader.  If the trader is wrong about the direction of the stock, he or she can afford for the stock to now move up $5 -- the premium received for the put -- to a level of $100-3/4 before heading into losses.  The trader who only shorts the stock will be exposed to losses for any price above $95-3/4.

What if the stock falls?  If the stock falls far enough, the sell-write trader may be forced to buy the stock at $95 due to the short $95 put.  But, as the trader sees it, that's okay because he or she was going to have to buy it to cover the short stock position anyway.

The trade-off with this strategy is this:  Say the stock crashes to a price of $50.  The short seller would gain the full profit of $45-3/4 (shorts the stock at $95-3/4 and buys it back for $50).  The sell-write trader, even though the stock is trading at $50 will be required to pay $95.  The maximum the covered put writer could ever make, in this example, is $100-3/4 - 95 = $5-3/4. 

Again, it's all about risk and reward.  Neither strategy is superior to the other. 

There is another important point to consider with the sell-write.  In the above example, we said the trader might have to pay $95 with the stock at $50, right?  Remember, it is the long put position that decides whether or not to exercise it.  So, while you may be ready to close out the sell-write, even though you must pay $95 with the stock trading at $50, you do not have the choice!  It is up to the person who is long the put.  In these cases, it is sometimes best to simultaneously buy back the put and buy the stock, or unwind the position, even though it will result in less profit.

I have seen it happen where investors enter a sell-write, watch the stock plummet, and then wait to get assigned on the stock yet never do.  In the meantime, the stock runs back up, sometimes into losses, and they never get to profitably close out the trade. 

Buy-writes and sell-writes are nice strategies to understand because they allow you to get more favorable pricing from the market makers.  After all, you are presenting them with two trades rather than one so you can definitely give yourself an edge.  In addition, you are aiding the market makers in their "three-sided positions" (please see our section during week 11 on synthetics), so they are eager to work with multiple orders. 

If you like covered calls, you should take the time to explore buy-writes!  The 1/4 and -1/2-point differences (or more) can make a huge difference at the end of a trading year.