Covered call writers generate cash flow by selling call options associated with a stock or exchange-traded fund. Our goals are to generate the highest possible returns with low-risk trades and that fit our requirement for capital preservation. The three required skills for achieving these goals are stock (or ETF) selection, option selection and position management (exit strategies). In this article, I will discuss a fourth, less apparent skill, negotiating a better price with the market-maker.
Market-makers generate profits from the bid-ask spreads…the greater the spread the more money they make. From their perspective, they want to buy as low as possible and sell as high as possible. To protect retail investors from large spreads, the SEC has established the Show or Fill Rule also known as the Limit Order Display Rule or technically the Exchange Act Rule 11 Ac1-4. This regulation requires market-makers to show or publish any order that improves the current “bid” or “ask” prices unless it is filled. Any order between the bid and the ask will improve the market.
When the spread is small, say $2.50 – $2.60, we don’t have that much to work with. But what if the spread was $2.50 – $3.00? If we placed a market order, we would most likely get filled at the bid price of $2.50 and there may have been an opportunity lost. Instead, let’s leverage the Show or Fill Rule: Find the mark or mid-point of the bid-ask spread and drop down slightly in favor of the market-maker and place a limit order at that price. In this case, the mark is $2.75. I would place a limit order to sell the call option at $2.70, not $2.50. Now the market-maker is faced with a dilemma…execute our trade for $2.70 or publish the new spread at $2.50 – $2.70. The $0.50 spread now becomes a $0.20 spread. It is now in the hands of the market-maker. In many cases, we will get executed at $2.70 and the published spread will remain at $0.50 as we pocket an additional $20.00 per contract. Covered call writers are in the business of selling options. These $20.00 “bonuses” will add up over an investment lifetime.
Real-life example as of market close 4-17-15
- Spread: $2.00 – $2.35
- Mark: $2.17.50
- Place limit order to sell covered call at $2.15
One more thing: Our trade execution forms have an All or None (AON) box. Do not check this box. If we do, the market-maker is no longer obligated by the Show or Fill Rule.
Enjoy the extra cash!
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US economic data stabilized, adding to speculation that the Fed could raise rates in September. Fed policymakers indicated the pace of further rate hikes could be slowed after this year, and US stock indices rose in response to this less aggressive stance. The Greek government appeared no closer to a deal that would help avoid a potential default on repayments due to the International Monetary Fund at the end of June, raising the risk that Greece could exit the Eurozone. This week’s economic reports:
- The US Federal Reserve still expects to begin increasing interest rates this year with the benchmark short-term interest rate expected to remain below 3% through December, 2017
- US housing starts fell 11.1% in May to a seasonally adjusted annual pace of 1.04 million units
- However, permits for future home construction rose 11.8% to 1.28 million units per year, the highest since August 2007
- The National Association of Home Builders/Wells Fargo builder sentiment index climbed to 59 from 54 in May, another indication of growing strength in the housing industry
- US consumer prices rose 0.4% in May, the most in two years, caused mainly by a 10.4% increase in gasoline prices
- Overall prices were unchanged from a year earlier, while core prices rose 1.7%
- Initial jobless claims fell 12,000 to 267,000 for the week ended June 13th, the fifteenth straight week below 300,000
- Continuing claims declined 50,000 to 2.2 million for the week ending June 6th
- The Conference Board’s index of US leading economic indicators rose 0.7% in May, better than expected
For the week, the S&P 500 rose by 0.76% for a year-to-date return of 2.48%.
IBD: Confirmed uptrend
GMI: 5/6- Buy signal since market close of May 11, 2015
BCI: Cautiously bullish but concerned over situation with Greece and how the markets respond. Next week should create more color on this issue. In the interim, I am selling an equal number of in-the-money and out-of-the-money strikes but expect to get more aggressive once this matter is resolved.
Wishing you the best in investing,
Alan ([email protected])