Alan Ellman discusses how to trade buy-writes, also known as net-debit limit orders which are executed at one price.
Covered call writing trades can be entered by legging-in (attempt to buy stock and sell option separately to get an edge on one or both side) or as a buy/write trade (one net-debit limit order). In the latter order, the option premium is deducted from the stock price and the broker is required to execute the trade at that price or better or the trade will not be executed.
Here is a real-life example with M.D.C. Holdings, Inc. (MDC)
On Feb. 13, 2020, a subscriber, Patrick, sent me information on his first covered call trade using the buy/write combination form. Here is his trade:
- Feb. 13, 2020: Buy MDC and sell the March 20, 2020 45 call option for a net-debit limit order of $43.15. The order was accepted and executed at the $43.15 price
Broker trade form showing the executed trade
MDC Buy/Write Trade Executed at $43.15
The brokerage statement shows that MDC shares were purchased at $44.33 and the 45 call was sold for $1.18, resulting in the $43.15 debit.
Initial calculations using the Ellman Calculator
MDC: Initial Calculations
The trade generates a 36-day initial time-value return of 2.7% with an additional upside potential of 1.5% if shares move up to the $45 strike by contract expiration. This is a potential 4.2% return, 42.6% annualized.
What price should we use as the cost-basis for the stock?
When analyzing the stock portion of the trade, the brokerage statement tells us that share price was executed at $44.33. We use this figure for our management decisions. For tax purposes, our advisor may use a different stat depending on the ultimate outcome of the trade.
Discussion
Buy/write trades, also known as net-debit limit orders are executed at one price. The brokerage statement will break down the share cost and option premium that resulted in the stated net-debit limit order.
Use the multiple tab of the Ellman Calculator to calculate initial option returns, upside potential (for out-of-the-money strikes) and downside protection (for in-the-money strikes). All the different covered call strategies listed above are explained in full on the Blue Collar Investor Website.
