Yesterday, following several days of aggressive call buying, I executed a new buy-write in Square (SQ). Oftentimes after making a buy-write recommendation, I get questions on how I choose the strike to sell. So I thought I would go through my thought process with this trade.
The input that most affects my thinking on how aggressive to be when executing a buy-write is my current evaluation of the overall market. A stock can have a great chart, earnings and long-term potential but if the overall market is trading sideways or lower, most stocks will generally trade in line with the market. And for months, the S&P 500, Dow and Russell 2000 have gone nowhere. Because of that, plus the big call selling in financials I noted on Monday, I believe the market is likely to be stuck in a choppy range. For these reasons, I went conservative with my buy-write.
Another reason I went more defensive with our Square Buy-write was the stance of Cabot Growth Investor’s three market timing indicators, which have turned slightly more defensive in the past week. Mike Cintolo, Chief Analyst of Cabot Growth Investor, notes that the Cabot Tides (which are a read on the market’s intermediate-term trend) have turned neutral, while his Two-Second Indicator (a measure of the broad market’s health) has been wobbly. His longer-term Cabot Trend Lines are still firmly bullish, but the risk of a market decline (or simply further reverberations after last week’s selloff) are growing.
So because I think the upside in the market is somewhat limited, I chose to sell an in-the-money call, which is more conservative vs. an out-of-the-money call, which is more aggressive. Here are the details on the price I got filled, and the risk/reward scenarios if I had chosen an out-of-the-money call.
July 21 in-the-money call I bought:
Bought Square (SQ) at 21.27, Sold July 21 Calls for $1.30
Static Return: 5.15%
Breakeven: 19.97
Covered Call Return (if assigned): 5.15%
Had I chosen to sell July 22 Calls:
Buy Square (SQ) at 21.27, Sell the July 22 Call for $0.80
Static Return: 3.90%
Breakeven: 20.47
Covered Call Return (if assigned): 7.47%
As you can see, the breakeven on the buy-write I executed is $0.50 lower than the more aggressive buy-write. That is the advantage. However, because I chose an in-the-money strike, the most I can make on this trade is the 5.15% yield, which is less than the potential 7.47% profit on the more aggressive trade.
Which buy-write will turn out to be the correct one? Only time will tell. And perhaps I should have simply bought calls (especially after a trader bought 3,000 December 20 Calls for $3.70 this morning, following the big buyer of December 19 calls yesterday).
Also, as I noted in yesterday’s Trade Alert, buy-writes and put sales have the same risk/reward profile, so executing the July 21 Buy-Write is the same as selling July 21 Puts.