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Covered-Calls 101

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Understanding Liquidity

Among retail market participants, liquidity is a subject seldom discussed and rarely understood. This lack of concern is reasonable, given today's efficient financial exchange systems, as there are few occasions when liquidity presents a problem for the average trader. Nevertheless, a covered-call writer - especially one who sells in-the-money options - must be aware of how liquidity effects option prices in order to implement the strategy effectively.

By definition, liquidity is the ability to buy or sell an asset quickly and in large volume without substantially affecting the asset's price. From a more practical viewpoint, liquidity refers to the level of trading activity in a particular security. For a person who writes covered-calls, an absence of liquidity is undesirable as there is tangible risk in not being able to sell the option for the expected amount, after the underlying shares are purchased. Indeed, the one aspect of liquidity that affects all option traders is whether there is enough volume in a specific series to keep the contracts fairly valued. The less liquid the market, the wider the bid/ask spread will be thus the more an option buyer will pay, or the less an option seller will receive, when a position is initiated. Additionally, a lack of interest in a given option series may increase the cost of, or reduce the proceeds from, future (exit or adjustment) trades.

Since transaction volume is the essential component of liquidity, it stands to reason that traders should try to avoid situations where there is an obvious dearth of buyers and sellers. This condition is evidenced by the daily level of trading activity and the current open interest; the number of outstanding contracts in a specific option. (Outstanding contracts are those which have been traded but not yet liquidated by either an offsetting transaction, or an exercise, or assignment.) Although there is no hard and fast rule that defines a liquid market, if less than 50 to 100 contracts change hands on a daily basis, it may be difficult to trade that particular option effectively. Keep in mind, the exchange specialist or market maker controls the pricing in a thinly traded option series, as he takes the opposing position in many of the transactions. Although the primary task of the specialist is to maintain a fair and orderly market in a specific security, he does not provide this service for free; he gets his compensation from you, the competition, and he is a formidable adversary.

Fortunately, a covered-call writer has some leverage in illiquid markets because the most profitable transactions for specialists are often deep-in-the-money calls and puts, which usually have large bid/ask spreads, due to the lack of liquidity. Consider the mechanics of a common covered-call trade where an individual has purchased shares of stock and subsequently places a limit order to sell deep-in-the-money call options:

XYZ stock purchased at $20.25

XYZ $15.00 Calls; Bid = $5.50 Ask = $6.00

Limit Order; Sell (10) XYZ $15.00 Calls @ $5.75

Expected Cost Basis = $14.50 Maximum ROI = 3.4%

If there is no existing demand to cross the trade, the market maker can simply post the offer to sell the calls, thus changing the bid/ask spread to $5.50 X $5.75. He may also choose to fill the order personally, either with an outright purchase (a directional position) or through the use of a reverse conversion. (A reverse conversion, or reversal, involves the creation of a short synthetic call; short stock and short put, to offset the purchased calls.) When the market maker executes the transaction, the published bid/ask spread will remain the same; $5.50 X $6.00, and if the next buyer purchases calls at the ask price, the position will yield a profit. If no retail demand emerges, he can always initiate the reversal transaction, selling the synthetic calls (without commission costs) to create a low-risk, non-directional position. Obviously, this assumes the put option is fairly priced (which is generally the case when a stock is in a bullish trend) and the stock can be sold short at the current bid. Any delay in the execution of the remaining (reversal) components will put the position at risk for the specialist.

Liquidity is an important part of the trading process, especially with regard to strategies that depend heavily on small disparities in option pricing. Greater trading activity generally creates additional liquidity through competition, thus providing better prices for both buyers and sellers. In those cases where retail interest is minimal, market-makers and exchange specialists have the responsibility of maintaining liquidity for certain option series. They use personal funds to add depth to the market, ensuring that trading is efficient with fluid price fluctuations. Keep in mind, however, the presence of liquidity does not necessarily guarantee a favorable option trade. Only those participants with a fundamental knowledge of pricing theory can determine when an option is fairly valued and that's a skill we'll discuss at length in future segment of Covered-Calls 101.

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