Lipper Research Senior Analyst Don Cassidy on "Business for Breakfast" 1060 KRCN Tuesday - Buy and Write
Tuesday, October 11, 2005
Q. Don, there has been a lot of buzz lately about so-called "buy and write"funds. Can we talk about these?A. Sure. But I think maybe first we need to go over what the underlyingstrategy is.
Q. Correct... what does it mean to say "buy and write?"
A. It is a little foreign to many investors. Most people buy stocks andhold them, maybe collecting some dividends, and that's as far as they go.(Most stock funds do the same thing for you.) But you also can sell or"write" call options against the stocks you own. Some people buy calloptions speculatively, hoping a stock will go up. Someone has to be sellingor writing that option, in order for those people to buy it.
Q. OK, so why would you sell an option against a stock you already own? Itsounds like betting against yourself.
A. There are several reasons, some tax and timing related. But the majorreason of interest is to get more cash income out of your assets.
Q. How does that work?
A. When you sell or "write" a call option, the buyer of that option paysyou some cash, called the premium or the price. They have the right but notthe obligation, anytime until the expiration date, to call the stock awayfrom you at the agreed price. If you had perfect foresight, and knew thatthe price would be unchanged at the end of that period, today you couldwrite an option that would expire worthless and not have the stock calledaway and keep the premium you got as well as any dividends.
Q. Maybe an example will help...
A. Sure. Sara Lee is trading at about $18.75 a share. If you own it, youget about a 4.2% yield on the dividend, plus the chance the stock willrise. You could write an April 2006 call at $20 a share, and get a premiumof about 50 cents a share. If the stock closes anywhere below $20 in April,that whole 50 cents becomes profit to you. And you still own the shares andhave collected your dividends. If you could do that twice a year, you'dget $1.00 extra per share or an extra return of almost another 5.5% on your$18.75 value. Assuming the price finishes unchanged!
Q. So why would funds do this?
A. Wall Street knows that investors are not in a speculating mood. Rightnow people like the idea of current income, but bond yields are fairly lowand bonds carry price risk if rates rise. So they can attract money bycreating new funds that will do a buy and write strategy for you, instocks. The funds buy stocks with dividends (giving some yield) and thenalso write options against those stocks, creating added net income.
Q. Seems almost too good to be true. Is there a catch?
A. Yes and it's found under the heading of "no free lunch on Wall Street."If you write options against your holdings, you are selling away the chancefor capital appreciation beyond the strike price of the option. In thatSara Lee example, if the stock in April is anywhere above $20.50, you willhave sold the buyer of the option all the further gain, whether that's to$21, or to $25 or $30, or whatever.
Q. So these funds would provide higher current income, but would not begreat choices if the market decides to go up.
A. Exactly!
Q. And what if the market goes down?
A. Well, your return would be a little less negative than if you had notwritten the options and earned those premiums. But you would still own,through the fund, a portfolio of stocks that has gone down.
Q. But in a down market, don't stocks paying dividends tend to fall lessthat those not paying any cash?
A. Sure, but we are talking a matter of degree -- of smaller losses. In thelast bear market, which admittedly was deeper than average, the more matureand higher-yielding S&P 500 went down about 45% while the NASDAQ fell about80%. So there is some cushion, but people should not see these buy andwrite funds as major sources of insurance against loss. They do not providethat function.
Q. So who would buy or own these funds now?
A. Someone who believes that stocks will continue going basically sidewaysand who thinks bond yields will rise.
Q. Is there a better, or a worse, time to buy a buy & write fund?
A. The only good time is when the market is going to be flat. If the marketis up (and will fall, to correct) you'd be buying stocks high if you buythe fund. If the market is low and you buy the fund, for the sake ofgetting a little extra income from the options, you will be giving awaymuch of the possible price appreciation as the market recovers, because theoption holders will tend to call the stocks away from the fund.
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Don Cassidy is a Senior Research Analyst at Lipper specializing in fund flows, exchange-traded funds, (ETFs), closed-end funds, equity fund performance, and author of Trading on Volume (McGraw-HIll).
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