There are two ways to enter a covered call position. The first is called legging-in where the stock is purchased and then the option is sold. Two distinct trades are executed. The second is known as a buy-write order where the security purchase and option sale is entered as one trade with a net debit limit order.
Buy-Write (Net Debit) Order: Some brokerages (OptionsXpress.com, for example) have set up a special combination order type to allow all elements of a covered call trade to be entered at one time. This order type is called a buy-write or net debit order. With this order type, we enter a limit order (execution at a specific price or better is specified) in the form of a net debit. Net debit simply means that WE owe the brokerage money, we pay them. For example, if we buy a stock for $20 and sell the call option for $1, the net debit is $19, excluding commissions. Since the order is specified as a limit order, we pay $19 per share (or less/better) for the order to be executed. The commission for this trade may be slightly less than the cumulative commission charged for each of the two executions warranted to affect a trade by legging in.
Opening a Covered Call Position Using a Buy-Write
Let’s look at an example of such a buy-write order (Figure below). In this hypothetical, we will purchase 300 shares of Blue Collar Investor Corp. (BCI) and sell the next month’s call option. Here are the current statistics for this hypothetical example:
- Current (Ask) price for BCI Corp. is $28.20
- Current (Bid) price for BCI- January $30 call is $0.70
- Net debit is $27.50
(slide made with old option symbology)
Achieving a more favorable fill (execution) for your order can be accomplished when using this combination order type by slightly lowering your limit net-debit order. Thus, in the example detailed above, you may use $27.45 or $27.40, depending on the spread of the option bid-ask price. The larger the bid-ask spread of the option, the better the chance of getting a more favorable fill.
Let’s look at the entries on this combination form to open a covered call position:
- Buy 300 shares of BCI
- Sell-to-open 3 contracts of the January $30 call option
- Limit net-debit order for $27.50 (or less, if “playing the bid-ask spread“…see pages 223-227 of Encyclopedia.…).
- Select Day Order– this order is good for the day only, as opposed to “good until cancelled” order, which stays active until specifically cancelled by the investor. A day order is the best duration for covered call writers. If our order is not filled the day it is placed, we can re-evaluate the trade returns the following day, as implied volatility may change. This then could impact the option premium and our calculations will to be re-evaluated.
- Do not select Advanced Order– . This order is not dependent on any other event.
- Preview– Check to make sure the order is correct, and if so, place the order.
Closing a Covered Call Position Using a Buy Write Combination Order
Next, let’s turn our attention to the chart below to see how we can use a combination order type to close our covered positions. For purposes of this chart, assume the following: Two weeks later, BCI is trading @ $28.50 per share (bid)
- BCI- Jan. $30 is trading @ $0.10 (ask)
- Net Credit is $28.40
Let’s look at the entries detailed on the above chart wherein we use this combination order form to close our covered call position:
- Sell 300 shares of BCI
- Buy-to-close (buy back) the 3 January $30 call option contracts
- Limit net-credit order for $28.40 (or more, if playing the bid-ask spread)
- Select Day Order–
- Do not select Advanced Order
- Preview– Check to make sure the order is correct, and if so, place the order.
Mathematics of closing the position:
Net credit – net debit = Net Profit: $28.40 – $27.50 = $0.90
Percentage return = Net Profit/Cost basis = $.90/$27.50 = 3.3%
Legging-in and buy-write combination orders are the two order types by which a covered call position can be established when the underlying equity is not yet owned. Buy-write order types are particularly useful when you can’t get to your computer to affect trades on a regular basis. Bear in mind, however, that not all online brokerage firms offer the buy-write order type. I strongly suggest learning legging-in as well because many situations will arise were we are selling options on shares already owned or closing the short options position while retaining the long stock position.
Live events for 2013:
- January 19, 2013: AAII Milwaukee Chapter
- February, 2013: The Money Show’s Stock Traders Expo @ The Marriott Marquis Hotel, NYC
- April 20, 2013: Atlanta Options Investor Club
- May 14, 2013: Long Island Stock Traders Meetup
- September 17, 2013: AAII Philadelphia Chapter
- November 9, 2013: AAII Chicago Chapter
***Thanks to those who attended my Chicago seminar. I appreciate all the positive feedback and the phenomenal attendance.
If you have a group of 75 members or more and would like a live covered call writing presentation send an email to:
Please include contact information, number of members and the venue. We will get back to you to discuss arrangements.
Thanks for your support:
I have been voted one of the “50 Great Writers You Should Be Reading” and will be included in an upcoming book published by The Business Author’s Show. I am humbled by this honor and grateful to you “putting me on the map”
- October’s consumer price index (A widely followed indicator of inflation. The CPI is a measure of the average change over time in the prices paid by urban consumers for a fixed market basket of consumer goods and services. The “core” CPI excludes food and energy prices, which account for roughly one-quarter of the broad CPI and tend to fluctuate widely, providing a truer reflection of inflationary trends) rose by 0.1%, stabilizing from the 0.6% increase the previous 2 months
- The producer price index (A measure of the average change over time in the selling prices of a fixed basket of goods by stage of production, industry, and commodity. It is considered a leading indicator for consumer inflation. The “core” PPI excludes food and energy prices—which account for roughly one-quarter of the broad PPI and tend to fluctuate widely—providing a truer reflection of inflationary trends) fell by 0.2% in October, the first decline since May, due mainly to a 0.5% reduction in energy goods.
- Retail sales dropped by 0.3% in October as a result of Hurricane Sandy impacting auto sales, retailers as well as electronic and appliance sales.
- In the minutes from the October 23rd-24th policy meeting, the Fed mentioned a new bond-purchasing program for December to enhance economic growth.
- Industrial production dipped by 0.4% in October (an increase of 0.2% was anticipated) as once again Hurricane Sandy impacted output of utilities, chemicals, food, transportation equipment as well as computer and electronic products.
- Business inventories (A report of the dollar value of product inventories held by manufacturers, wholesalers, and retailers. Included in the report is the inventories/sales ratio, a gauge of the number of months it would take to deplete existing inventories at the current rate of sales, which is an important indicator of the near-term direction of production activity) rose by 0.7% in September as retailers are getting more comfortable maintaining and enhancing inventories.
For the week, the S&P 500 declined by 1.4% for a year-to-date return of 10.3%, including dividends.
IBD: Market in correction
BCI: Long-term bullish but short-term extremely cautious using in-the-money strikes, low-beta stocks and ETFs. Less experienced investors should consider keeping some cash on the sidelines.
Much success to all,
Alan ([email protected])
The Weekly Report for 11-16-12 has been uploaded to the Premium Member website and is available for download.
Also, be sure to check out the latest BCI Training Videos and “Ask Alan” segments. You can view them at The Blue Collar YouTube Channel. For your convenience, the BCI YouTube Channel link is:
Since we are still in Earnings Season, be sure to read Alan’s article, “Constructing Your Covered Call Portfolio During Earnings Season”. You can access it at:
Barry and The BCI Team
In this article you mention low beta stocks. Where can I get beta information and how do you use it? Thanks a lot.
Historically, low-beta stocks tend to outperform in bear markets and high-beta stocks tend to outperform in bull markets. Although we use beta as a secondary consideration, it is still a valid and useful tool. A FREE resource is:
2- Type in ticker and “get quote”
3- Under “Company”, hit “Key Statistics”
4- Beta under “Trading Information”
What is the formula you use in your calculator for downside protection and please explain. Thank you.
In the BCI methodology, downside protection refers to the protection of the intial profit (time value of the premium). It is NOT the same as the breakeven. Here’s an example:
Stock price = $32
$30 call = $3 (breakeven is $29)
Initial profit (ROO) = 1/$30 = 3.3% (use the intrinsic value to “buy down” the cost basis from $32 to $30)
Downside protection = $2/$32 = 6.3%
This means that our 3.3%, 1-month return is guaranteed as long as the share price dows not depreciate in value by more than 6.3% by expiration Friday.
Running list stocks in the news: MYGN
On November 5th, Myriad Genetics reported a stellar 1st quarter earnings report with earnings-per-share up 24% year-to-year beating estimates by 12.5%. Revenues increased by 21%. This was the 7th consecutive positive earnings surprise with an average beat of 9.1%
MYGN raised its outlook for fiscal 2013 reflecting a growth rate of 15-18%
Our premium watch list shows an industry segment rank of “A” and a beta of 0.94.