Buy-Writes and Legging Into Covered Calls
Covered Call Review
This article, on the topic of Covered Calls, will address three things: Buy-Write, Legging In, and the use of the MACD histogram as a timing tool for the sale of Covered Calls. Prior to addressing these three points in greater detail, let us turn our attention to what a Covered Call actually is.
Basically, when selling a Covered Call we are, in fact, giving to the other side (either trader or investor) the opportunity to buy our stock at the strike price that we select either on or before the expiration day of the particular call. Normally, the seller of a Covered Call selects the near month. If the price of the underlying closes higher than the sold strike price at expiration, then we get "called out" meaning our stock gets taken away from us.
However, we did get compensated for our willingness to sell the stock up front, and the premium that we have received from selling the call is ours to keep no matter what the outcome is. If the stock remains below the strike price at expiration, then in that case we keep both the stock as well as the premium.
Part One: Buy- Write
Now let us move to the Buy-Write part of this article. The Buy-Write Covered Call strategy involves the simultaneous actions of buying a stock and selling a call. The word Write implies option selling, while the term Buy-Write implies call option selling against shares that are either borrowed or actually owned.
Part Two: Legging In
Next, let us compare how Buy-Write is different from Legging In. Whenever we Leg In to a Covered Call, we first purchase, let’s say, one hundred shares of stock and then later on, we sell one call against them either near the money, or if we want to leave room for upside potential in the stock, then we sell one (out-of-the-money) OTM call. In terms of delta, this is what is happening behind the screen.
When we purchase one hundred shares of stock, our delta is positively correlated with the stock and it reads plus 100. If we choose to sell either an ATM or OTM call later on, we are reducing our positively correlated delta by the amount of delta that we sell. In other words, in exchange for this receipt of premium, we are capping our upward potential while maintaining all of the downside potential. We can’t protect our downside by placing a stop loss on the long stock unless we first buy back our sold call.
Just imagine the scenario in which our stock stop loss closes our equity position leaving us completely exposed with a naked short call. At Online Trading Academy, due to the risk associated with naked short options, they are reserved for a few very specific market conditions. (In case one is wondering, one way to overcome the downside exposure on a Covered Call is the Collar, an option strategy that will be addressed in future articles.)
Part Three: Timing
For the timing of Covered Call selling, there are many different technical indicators that could be used. Rather than going to the list of them, I will explain the one that I use solely for that purpose. It is the MACD (Moving Average Convergence Divergence) histogram indicator that I use when selling Covered Calls. I use the MACD histogram as a tool that assists me at picking an optimal point to sell the calls. The indicator displays a value that looks like the cosine or sine curve.
Do you remember college trigonometry class? I have heard some traders calling these fluctuations mountain peaks and valleys. Whichever term one chooses to use, the indicator still displays the same thing. A strong underlying creates higher readings on the MACD histogram, while a weaker underlying shows lower readings. I like to use the MACD histogram in the following way: When the readings of the MACD histogram start to decrease on the year daily chart for several consecutive days, then I interpret those readings as the first sign of weakness.
The chart below shows a decreasing MACD histogram (green line and the yellow oval, on the lower studies), and observe that at the same time the underlying price action is stalling and failing to move higher (green line on the chart). This signals that it’s time to sell calls against the underlying stock.
Covered Calls are one of the most utilized option strategies. Due to this fact, just about all brokers that I know permit trading Covered Calls in a retirement account. A year ago I wrote the article, Back to the Basics: Part 3, where I laid down which options strategies truly represent risk to the broker.
To those interested in finding out which ones are the riskiest, I suggest clicking on the link. After reading it, you will notice that Covered Calls aren’t on the list of those strategies representing a serious risk to the broker. Why would it? The broker has all the trader’s money and the trader has all the risk.
Lastly, from emails that I have received, I could tell that a lot of Online Trading Academy students are confused about how to find a buyer, or to whom to sell their covered calls. Here is the simple answer; you don’t need to worry about finding a buyer. The option market is unlike the real estate market in which the broker who has taken the listing must find the buyer.
In the option market, it is the Floor Brokers at the option exchanges who are the matchers, for he or she matches our sell order with a buyer who is willing to buy. We, as the seller, will never actually have to meet the buyer of our call options.
In conclusion, Covered Calls can become a cash flow producing strategy for us. We do get paid in advance, yet at the same time we also take on the obligation to sell our stock if it goes above the sold strike price either on or just before expiry. A Covered Call, in my opinion, is less risky than just holding on to the stock.
By selling a Covered Call, at least we have a small downside protection in the amount of premium that we have taken in. If the stock declines in price, the premium is the cushion that can help us to survive the bumps on the uptrending road.
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