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Covered Calls IV - The Final Frontier

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What do you think so far? Weve gone through the covered call strategy quite thoroughly. There is a lot to think about when (preferably before) using covered calls. Its not a complicated strategy, but millions of people, who dont know what theyre doing, are selling covered calls. Some may get lucky here and there, but, if they dont know how to protect themselves and/or when to get out of a position, they can get hurt. They end up with a portfolio of loser stocks that went down and stayed there!

The Buy-Write

Many covered call traders are simply selling call options on stock they already own in an attempt to generate a better return on their investment. Others, however, will go out and buy stock specifically for the purpose of selling calls against it.

There are two ways of entering such a position.
1) Place an order to buy the stock. Then, after the stock order is filled, place an order to sell the call option. This is a two-step process and is the one used by most traders because its all they know. However, it may not be the most efficient way.

2) Place an order to buy the stock and sell the option simultaneously for a net debit a one step process. This is called a buy-write buying the stock and writing (selling) the call at the same time.

How would we place a buy-write using our JNPR example? Lets say . . .
JNPR is trading at $21.20 x $21.40 (bid x ask)
$22.50 option is $1.45 x $1.55 (bid x ask)

We learned in earlier columns that there is always a spread between the bid and ask prices. The bid/ask spread is where the market maker makes his living. If we want to buy JNPR (or option) immediately, we simply pay what the market maker is asking -- $21.40. The order will be filled instantly. However, if we want to save a few bucks, we can try to negotiate with the market maker. Instead of paying the $21.40 for the JNPR, perhaps we would offer $21.30 or $21.35. Maybe he will compromise maybe not. If the negotiation attempt order is not filled right away, you take the risk of the JNPR moving up while youre waiting. If it moves up, you may end up paying more than the $21.40, which defeats the purpose of trying to save a nickel or a dime.

If/when your stock order is filled, you may go through the same process trying to fill your order to sell the covered call. If you choose not to negotiate, you wont have this problem. You wont save any money, but you wont have to spend the time and take the risks associated with working the orders.

The buy-write allows you to place the stock and option orders as a single order for a debit limit. More progressive brokers will have screens on their trading platforms that enable you to place these buy-write orders. Here are a few examples as to how you would prepare to place a buy-write order.

a) Buy 1,000 shares of JNPR and sell 10 contracts of JNPR $22.50 calls for a debit of $19.95. This is the debit limit we would use if we did not want to negotiate. It consists of buying at the $21.40 ask on the JNPR shares and accepting the $1.45 bid price on the $22.50 calls.

b) Buy 1,000 shares of JNPR and sell 10 contracts of JNPR $22.50 calls for a debit of $19.80. What weve done here is take the amount wed like to pay for the JNPR stock ($21.30/share) and subtract the premium we would like to receive for the $22.50 covered call ($1.50/share). This figure is our attempt to negotiate a little (about $.15) from the bid/ask spreads of the stock and the option. Now, $.15 may not sound like a lot. But, on 1,000 shares and 10 contracts, it amounts to $150. Thats meaningful at least to me. Its 150 double cheeseburgers!

So, you can initiate a covered call either way. If youre interested in the buy-write method, call your broker and see if they have the capability of entering the buy-write. If they dont, you have the wrong broker.

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A Covered Call Exercise Alternative

Heres something to consider for those of you who may be selling covered calls on stocks that you already own. Some folks are reluctant to sell covered calls on stocks because they are concerned about having the stock called away from them. Their stock may have been purchased a zillion years ago at significantly lower levels and, if called away, there would be substantial capital gain tax implications.

Now, as much as we all LOVE to pay taxes, we dont want to give Uncle Sam any more than we absolutely have to. Agreed? With covered calls there is some flexibility that is tax friendly. On Monday following expiration, when you are notified that your stock has been called away, there are three days before the transaction settles. All stock sales and purchases settle in three business days.

You have the time to go out onto the open market, purchase an equal amount of stock and designate the newly acquired shares to be the ones to be called away to satisfy the exercising of the covered call.

For instance, if JNPR closed at $24.10 at expiration, and you had sold the $22.50 call, your call would be exercised and your 1,000 shares of JNPR would be called away. However, if you buy another 1,000 shares at $24.10, you can designate the new 1,000 shares to be the ones called away. That way, you can avoid having to pay a capital gains tax. The new cost basis of $24.10 would apply to the shares called away not the cost basis from the original 1,000 shares.

You would have paid $24.10 for the new 1,000 shares and you would only receive the $22.50 from the covered call you sold. But, you are not out the $1.60. Remember, you still own the original 1,000 JNPR shares that have now appreciated by that same $1.60. So, its a wash and you still own the 1,000 JNPR shares.

Who Is This Guy? --

Mike Parnos has "been there and done that" - plenty! Known as the MasterTater and "Options Therapist," Mike has been writing the profitable and popular Couch Potato Trader column (for OptionInvestor.com) for almost five years. Hes been trading, consulting and teaching option strategies for over 12 years. Both individually, and through his writings, Mike specializes in teaching conservative and non-directional option strategies while providing therapeutic guidance to thousands of individuals, brokers and institutional traders.

For serious traders, Mike offers a comprehensive two-day seminar covering many fascinating and profitable non-directional strategies. Feel free to send questions and/or comments to Contact Support.

Over the years, he has learned from his mistakes, and the mistakes of others, and he's here to share his wisdom with you. "Trading is as much psychological as it is skill," says Mike. "Keep an open mind. You never know what might find its way in there."

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