Executing a covered call trade and understanding the accounting procedures on our online discount broker statements can be confusing to the new option trader. I have recently received a few emails regarding this topic so I thought it would be useful to show an actual trade I made with KORS, a stock on our Premium Watch List at the time this article was written. The four steps we will review are:
- Purchase 400 shares of KORS
- Confirm purchase
- Sell 4 September call contracts
- Confirm sale
Entering a covered call trade in this manner is known as legging-in. For information on using a buy-write combination form see pages 219 – 223 of my Complete Encyclopedia for Covered Call Writing.
Steps 1 and 2:
Since the bid-ask spread is tight (small difference between the bid and the ask), I placed a market order to purchase 400 shares and got executed @ $72.36:
Note that the total cost, including commissions is $28,949.15 and appears as a debit (red parenthesis). This appears in the “Activities” section of the brokerage statement.
Now that I own the shares and I’m in a covered or protected position, I am free to sell the call option. I decided to sell the near-the-money $72.50 September call option, slightly less than 1-month to contract expiration. Here is the trade execution form:
Please note the following:
- The first 6 lines are self-explanatory
- We enter a limit order, not a market order
- We enter a limit price based on the bid-ask spread shown in an options chain
- The order is day only
- ***DO NOT CHECK THE ALL OR NONE BOX when playing the bid-ask spread (224 – 228 of Encyclopedia…)
Next I checked the activity section of the broker statement (order status can also be checked) t0 see if the option sale was executed:
- 4 contracts were confirmed sold for a total of $931.03, including commissions
- My initial 1-month return is $931.03/$28,949.15 = 3.2%, 1-month return, after commissions
- Notice the option price dropped from $2.40 to $2.35 while I was creating these slides (took one for the team!)
- The contracts appear in red parenthesis because I am short these contracts (I sold them and have an obligation)
- Since I am long the shares, they appear in black and NOT in parenthesis
Positions section of brokerage statement:
This is the section that can get quite confusing. Although I generated $931 in cash from the sale of the 4 contracts, the option value will appear as a debit in this portion of the statement because the position is still open and may have to be bought back. Let’s have a look a couple of minutes after the trade was executed:
- As share value started to rise after the trade was executed so did the value of the option premium
- Option value appears as a debit (red) because the cost to buy back is greater than the premium received.
- This is deceiving because an increase in share value is a positive for us. This is simply an accounting technique used by brokerages which we must understand
- The 4 contracts also appear in red because I am short these contracts and still hold an options obligation
- The cash generated from the sale of the options IS in the cash portion of my account and available to trade with
- Once the options expire or are bought back or exercised the apparent debits and short positions are deleted from the positions section of the broker statement. The cash, of course, is ours to keep.
Brokerage statements will not all appear precisely the same but will be similar in many respects. When executing our covered call trades it is important to be aware of the accounting methods used by our respective brokers to avoid confusion. Be sure to fully understand your brokers platform before entering your first covered call trade.
Next live seminar:
September 24th: Philadelphia:
The market is awaiting guidance as to when the Fed will ease up on its bond-buying program. This has created a nervous but resilient market. This week’s reports:
- Existing home sales increased by 6.5% in July to an annual rate of 5.39 million, above the 5.16 million expected and the highest rate in 3 years
- Median price of homes rose by 13.7% from a year ago
- Inventories of existing homes remain 5% below the level of a year ago
- New home sales fell by 13.4% in July to an annualized rate of 394,000, the lowest level since October, 2012 but 7% higher than a year ago
- Median prices of new homes are 8.3% higher than a year ago
- Minutes of the July 30-31 FOMC meeting sent mixed signals as to when “tapering” of the Fed’s purchasing of Treasury bonds and mortgage-backed securities would begin. It appears that policy changes will be gradual and dependent on current economic conditions
- The Conference Board’s index of leading economic indicators (a composite index of ten economic indicators that typically lead overall economic activity. The index includes indicators such as housing permits, new orders for consumer goods, consumer expectations, and performance of the S&P 500 Index) rose 0.6% in July, better than anticipated. The growth rate in the past 6 months has nearly doubled, boding well for expansion in the near term
For the week, the S&P 500 rose by 0.5% for a year-to-date return of 18.3%, including dividends.
IBD: Market in correction
BCI: Cautiously bullish using an equal number of in-the-money and out-of-the-money strikes
My best to one and all,
Alan ([email protected])