First on the docket are questions about covered-call writing:
Steve, I have two questions regarding covered calls: 1. When one "rolls" a call to a higher strike price, does this mean buying back the covered call you had sold originally and selling a call at a higher strike price, thus requiring commission payments for the purchase of the first call and the sale of the second? 2. Why does rolling a call to a higher strike price reduce the downside protection? -- Dr. Shaffer
1. Yes, rolling the call would require the purchase of the previously shorted call. You will incur the commission costs associated with the two trades. 2. Downside protection is reduced because the higher strike call commands less of a premium (lower price) because it's further out of the money.
As many readers know, I'm a big proponent of using spread orders, which involves the simultaneously executing two or more option orders with different strike prices or expirations, whenever possible. They usually cut commission costs and achieve better execution prices. It also mitigates the risks associated with trying to "leg in and out" of positions. If you want to roll or switch, I recommend paying the transaction cost but avoiding the market risk.
Most brokerage firms offer a slightly lower transaction fee for simple spread executions. And now there's electronic trading -- specifically the International Securities Exchange's ISEspread feature, which not only tries to match the order in the spread book, but scans both the specialist and standing regular customer order book to possibly fill a spread. Launched last January, ISEspread's electronic "shopping of the order" has made spread markets tighter and more liquid than ever before.
Many people had concerns about selling covered calls when premiums are low as they are now. I've
covered this topic before, but I certainly haven't exhausted the subject. For those with extended attention spans, I recommend
New Insights on Covered Call Writing
by Richard Lehman and Lawrence McMillan.
For those with fairly broad holdings and a long-term time horizon, a cost-efficient way of integrating a covered calls strategy into your portfolio is through specific mutual fund offerings. Here are three funds that utilize covered calls to dampen risk and stabilize returns:
Dobson Covered Call,
Gateway Fund and the
Kellmoore Strategy. The mutual fund format removes much of the labor involved in stock picking and strike management (such as rolling, and worrying about exercises and expirations). And because of their size, funds can usually pass along their low commission structure in the form of relatively low fees. But, as always, do some homework and make appropriate decisions.
It Don't Add Up
A few people questioned my calculation in last week's
Forum example regarding the move necessary to break even if you pay the bid price on an option.
Steve, your math is wrong. If you were to buy the call for $3.50, XYZ shares would need to rise by 40 cents, or 1.3%, for you to break even.A rule of thumb that I learned from Tom Sosnoff, president of Thinkorswim.com and a 20-year veteran of the CBOE, is that market makers require a 5-cent edge over fair market value per option to trade with the public. Thus, if an option is trading at $3.30 bid, $3.60 offered, fair market value is the midpoint, or $3.45, and market makers will hit a retail bid of $3.50 ($3.45+ $0.05). This 5-cent edge rule applies to single options and simple spreads.
I appreciate Sosnoff's knowledge and credentials -- and thanks for the valuable insight -- but what works for a market maker doesn't always apply to retail or even professional traders. Rules of thumb, while providing a high success rate over time, are not mathematical facts. And even facts are subject to interpretation. As the Talking Heads explained:
Facts are simple and facts are straight
Facts are lazy and facts are late
Facts all come with points of view
Facts don't do what I want them to.
In last week's example, I was comparing buying a call at the bid of $3.60, which would need a 60-cent, or 2%, move in the stock (he seems comfortable with those numbers) to break even, to buying the same call at $3.50. I wanted to show that giving up a nickel here and dime there could greatly impede your ability to generate an overall profit. Mainly, I wanted to illustrate how important it is to get the best execution possible. As to whether the midpoint between the bid/ask truly represents "fair market value" is first of all questionable, and secondly, somewhat irrelevant to the discussion.
But admittedly, I should've been more specific with the variables I was plugging in -- the most important one being that I didn't say I was assuming the passage of two trading days from the purchase. Since most of our readers hold positions for more than a day, I thought this might more accurately reflect the bid/ask obstacle that needs to be overcome. This could explain some of the discrepancy in calculations.
As always, thanks for all the great notes and questions and please keep them coming.
Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to