Covered Calls & Buy-Write Strategies

The Smart Profits Report: Issue #339
Thursday, August 3, 2006

Covered Calls & Buy-Write Strategies: How to Get Filled at the Prices You Want
By Karim Rahemtulla
Chairman, Mt. Vernon Research

Today, I’m going to give you double your money.

I’m not just going to show you how you can profit from one of the most rewarding options strategies out there; I’m also going to show you how you can pinpoint those profits by getting filled on both your desired buy and sell price using both covered calls and buy-write strategies. So buckle up!

First, let’s deal with covered calls - one of my favorite options techniques. Why? Because they increase your profits and cover your risk - a pretty good combination. In fact, I often make sure that the majority of my portfolio is “covered” because it allows me to seek profits while also remaining conservative. Here’s how it works…

Covered Calls: How to Buy and Rent at the Same Time

A covered call simply means you buy a stock, then sell options against it.

Say you buy American Express shares at $50 apiece, with a 12-month price target of $55. If it hits that price, you sell and pocket 10%. Not bad - but you can do better!

You do it by selling $55 call options against your stock position. That means you can sell one option for every 100 shares owned and basically give another investor the right to buy the shares from you at $55 in 12 months. For that right, you receive a premium (in this case, let’s say it’s $1.50). I like to think of this as banking additional profits - you’re essentially collecting “rent” from the premium, as well as reducing the cost of the stock purchase. Here’s how…

You buy American Express stock for $50. But the $1.50 option premium cuts your cost to $48.50. If the stock hits your $55 strike price, that means your upside becomes $6.50 ($55 strike price minus $48.50). Compare that to the $5 profit you would make by buying the stock without an option ($55 strike price minus the $50 purchase price).

Buying American Express at $50 and selling at $55 is a nice 10% profit. But when you write a covered call option against the stock, it becomes a 13% gain. While this is a conservative example, you can see how the difference is calculated.

Selling an option against shares of stock you own does limit your upside, though. In this case, if American Express trades above $55 (your strike price), then the most you can make is $55, since you’re obliged to sell at your $55 strike price. But if that happens, you’re sitting pretty: Since you already made the disciplined decision to sell at $55, you have all the profit you originally wanted to make from the stock - and more (the $1.50 premium you received).

And if American Express closes below your $55 strike price by the expiration date, you simply keep the shares, as well as the premium received for the option.

By writing a covered call, you accomplish two things:

You reduce your cost and increase your upside.
You stick to your target price throughout.

That’s a pretty good deal. However, there is one drawback, which can deter some investors. Don’t be one of them. They simply don’t know that there’s a very simple and powerful way to overcome this obstacle. Here’s how…

Harness the Power of the “Buy-Write” to Always Get Filled at the Prices You Want

Because the covered call strategy requires buying both a stock and an option at your desired target prices, getting filled at those prices can be tricky. But not when you know how to use this little-known technique that gives you two benefits:

You enter/exit each trade at the buy/sell prices you want. This avoids “chasing” a stock and option trade simultaneously at the outset and allows you to obtain optimum profits.
If a trade never hits your price targets, you don’t get into it at all, thus ensuring that you preserve your capital.

By using a buy-write, you avoid the inadvisable “market order” request, where you basically tell your broker to fill you at whatever the current market rate is. Considering that options market makers can manipulate prices, this is a rather carefree and unpredictable way of trading.

The buy-write technique is also much easier than placing “limit orders,” where you’d have to set your buy price on the stock, verify that you were filled, and then execute the option trade the same way, using another limit order.

Having your broker execute a buy-write gives you increased peace of mind, while also providing you with the highest possible profits on each of your covered call trades.

Make Your Broker Do His Job and Earn His Money

A word of warning: Don’t let your broker talk you out of implementing a buy-write. It shouldn’t be a problem for a decent broker to do. If he’s reluctant, he’s probably just being lazy, because it takes a bit more time and attention to execute. But it’s worth it.

All you need to do is state two specific prices at which you want the entire order to be filled. You need a target price for the stock, and the same for the option you’re selling against it. The price you pay is called the “net debit” once the option premium is deducted from the price of the stock. Here’s an example…

How to Execute the Perfect Buy-Write Trade

You want to buy Active Power shares for $3 and also want to sell the $3 call option against them, with a bid price of $0.25. You simply tell you broker to execute a buy-write trade, where he:

Buys Active Power stock at $3
Sells the same number of Active Power $3 calls at $0.25

This guarantees that you either pay a net debit of $2.75 per share, or back away from the table. If you’re trading online, here’s exactly how you’d execute the trade…

Buy 1,000 Active Power shares (don’t enter a price on the buy-write screen).
Sell 10 Active Power options contracts (enter the symbol, but again, not the price).
It will then ask you for the “net debit.” This is where you enter your net target price. In this case you would enter $2.75. This means the trade will not be executed unless your net debit target price is met. Period. If it’s not met, the trade is not executed.

The only downside to a buy-write trade is that you may have to wait to get filled. But while the time element isn’t within your control, the price element is. And that means you control your costs.

Good Trading,

Karim Rahemtulla

Today’s Smart Profits Cribsheet

Before entering any options trade, you need to make sure that you do everything you can to maximize your profits. It’s a remarkably simple fact, but one often neglected by overzealous traders looking to pile into a trade without thinking. Read Smart Profits #261: Option Pricing: How to Get the Best Prices on Your Options, and get every trade off to the best possible start.

“If you own at least 100 shares of stock, and you’re not selling call options against it, then you are throwing away free money.” That’s according to Smart Profits Editor Lee Lowell, who spent six years as a market maker in the NYMEX trading pits in New York. Learn more about covered calls in Smart Profits #270, Selling Covered Calls: Getting Cash for Stocks You Already Own.

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