Executing covered call trades begins when we instruct our online discount brokers what we want them to do for us. When instructing our online discount broker as to the actions we want taken, we submit a customer order. These orders can take several different forms depending on our investment strategies and objectives. We can buy or sell; request a specific price or simply the best available price; we can stipulate an action given a particular circumstance; and we can use combinations of orders. Let’s look at the most common of these orders and the situations when we may utilize them.
This is the most common of customer orders where we ask the broker to buy or sell a stock or option at the best available price. It is also called an “unrestricted order” and will always be executed.
This is an order to buy or sell a specific number of shares at a certain price or better. A buy limit order can only be executed at the limit price or lower. A sell limit order must be executed at the limit price or higher. These are particularly useful on low-volume or highly volatile stocks.
An order to buy or sell a security when its price surpasses a specific price called the stop price. At that point the stop order becomes a market order. A sell stop order is placed below the current market value of the stock and is used to prevent or limit a loss or to protect a profit on a long stock position. For example, you may have purchased a stock for $20 per share and it has appreciated to $30. A sell stop order @ $25 will guarantee at least a profit of $5 per share (barring a gap-down in the price of the stock). A buy stop order is always placed above the current market price of the stock. It is typically used to protect a profit or limit a loss on a short sale (selling a stock you didn’t own by borrowing it). For example, if you sell short a stock @ $30 expecting to buy it back at a lower price but it starts going up in value instead, a buy stop order can limit your loss. It may kick in @ $32 thereby minimizing losses to $2 per share. Once the buy stop price is reached, the order becomes a market order.
Stop Limit Order:
This is a combination of a stop order and a limit order. Once activated, it becomes a limit order which means that it can only be executed at a specific price or better. The benefit is that the trader has precise control over when the order should be filled. The disadvantage is that it may never get filled. A sell stop-limit order is always placed below the current market price of the equity and is used to limit the loss or protect the profit on a long stock position. Once activated, it becomes a limit order. A buy stop-limit order is always placed above the current price of the stock and is used to limit a loss or protect the profit on a short stock position. Once activated, it becomes a limit order.
A trailing stop adjusts the stop price at a fixed percent or number of points below the market price of a stock. The purpose of the stop is to protect against a move by the stock or option price in the opposite direction from which you expect. When the price of your stock rises, the trailing stop rises with it, helping to protect you against a larger loss and eventually capturing a portion of your profit. With a trailing stop, you continue to hold the stock so you still receive the dividends from the stock, if they are paid. Should the stock plunge past your stop, your shares are sold at the next available price, not necessarily the stop price, assuming you have not placed the stop order with a limit price.
Summary of Orders entered Above the Market:
- Buy Stop-Limit
- Buy Stop
- Sell Limit
Summary of Orders entered Below Market:
- Buy Limit
- Sell Stop
- Sell Stop-Limit
- Trailing stop
Covered Call Trade Orders:
As discussed in previous articles, most writers of covered calls place their trades by legging in. This where a market or limit order is placed to purchase the equity and once executed, a second order (usually limit) is placed to sell the option. For maximum profits, these two legs should be executed simultaneously (Buy the stock and immediately sell the option. Do not buy the stock, go to the mall and then come back home to sell the option). Another methodology permitted by some online discount brokers (not USAA, the one I use) is to place a net debit order. This is where you buy the stock and sell the option at the exact same time, not for specific corresponding prices but for a limit net debit. For example, if a stock is selling for $20 and the A-T-M call is selling for $1.50, the net debit or amount we would owe is $18.50 ($20 minus $1.50). This way, even if the price of the stock and option change, the order can still be filled if it meets the requirements of our debit order. This would be particularly useful for investors who can’t be in front of their computers but want to execute a covered call trade. As stock investors and covered call writers it is critical to know and understand the different types of customer orders and the appropriate time to implement them.
Covered call limit order example:
In the options chain below, ULTA is trading @ $93.55 and the bid-ask spread is $1.95 – $2.30. Placing a market order may generate $1.95 but placing a limit order slightly below the mid-point @ $2.10 has an excellent chance at being executed for an additional $15 per contract:
Economic reports this past week were dominated by mixed housing information:
- New home construction decreased by 1.1% in February but still near a 3-year high
- Building permit applications rose by 5.1%, the highest rate since October, 2008
- The rate of housing completions was up 6.2% from January
- Single-family home starts were up 18% from February, 2011
- New home sales dropped by 1.6% in February, the second straight monthly decline but…
- New home sales rose by 11% from February, 2011
- The Conference Board’s leading economic indicators rose by 0.7% in February, the 5th consecutive monthly gain and an 11-month high
For the week, the S&P 500 fell by 0.5% for a year-to-date return of 11.6%.
A 6-month comparison chart of the S&P 500 and the CBOE Volatility Index (VIX) shows bullish signals:
- Uptrending S&P 500 (red arrow)
- Calming VIX (green arrow)
- Consolidating signals the last two weeks, perhaps a welcome breather (yellow fields)