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Editor’s Note: Due to onscreen examples and demonstrations, it is much more effective to watch the video then merely read the transcript on its own.
TRANSCRIPT
Welcome to the Dividend Multiplier covered call tutorial. I’m Marc Lichtenfeld. Today, I’m going to show you two ways to trade covered calls. The first is when you buy the stock and then sell the call. The second is to combine those steps into one trade, where you do them simultaneously. That’s called the “net debit” method. I’ll walk you through both.
Today, I’m using software called thinkorswim. It’s by TD Ameritrade and you can use it with any broker’s software. You can also go right to their websites – such as ameritrade.com, fidelity.com, etrade.com, etc. – and type in the orders right there. While it will look a little different, the instructions are basically the same.
Two things I like about using trading software, as opposed to going right to the website, is that it’s a little more robust and a lot of the brokers allow you to paper trade. That way, if you’re not comfortable diving right in, you can practice the mechanics involved in Dividend Multiplier and follow along with my trades as I recommend them each week without risking any of your own money.
Let’s get started by placing a paper trade on Intel, which was trading for $34.75 at last check. We first type in its symbol of INTC. Specifically, we want to look at the January $35 calls. As shown on the video, they’re trading at $1.35 on the bid and $1.38 on the ask. (Note: Anytime you’re looking at calls and puts, the calls will be on the left and the puts will be on the right.)
So what we’re going to do is very simple: Click on the ask to buy Intel. When you do that, you can see the order comes up to “buy 100 Intel at $34.75.” Now, it automatically comes up as a “limit,” but I’m going to put it in as a “market order,” then hit “confirm and send.” It then reminds me there’s a commission here. When I hit “send,” I get billed and my cash goes from $100,000 down to $96,527 because I actually bought stock. (Again, this is paper trading; I didn’t actually buy it in my real account.)
From here, let’s go ahead and sell the call. Remember: We want the January $35 call. The reason I picked that one is because it’s just above the strike price. If you go too far above the strike price, then the amount you’re going to get for the call is going to be much, much lower, and we want to get a decent amount of money. We also want to give it a little bit of upside if we can: We don’t want to go too low.
Staying above the strike price means there’s a better chance the stock will be called away from us if the strike price is below the current price. In an optimal situation, we want to collect the dividend on the stock and the stock to come almost up to our strike price, falling maybe a penny short. That way, the option expires worthless and we keep all the cash. We then can sell the stock for a slight gain.
So here’s what we’re going to do. We’re going to sell the January $35 strike. It’s $1.35 on the bid to sell and $1.36 to buy. Now, sometimes the options will have a much wider spread – let’s say $1.20-$1.50 – in which case, you probably want to try to get in between the spread, putting in an order for let’s say $1.35-$1.40. But in this case, it’s a one-penny spread, so you really could just do it at the market.
Here’s what we’re going to do: We’re going to make the sell by hitting the “bid” button. This next part is really important: Remember we bought 100 shares. Options are traded in 100-share lots, so that’s $1.34 or $1.35 roughly that we’re getting per share, or $135 per contract. So again, we bought 100 shares of stock. While the default is probably different broker to broker, ours comes up as 10. That’s 10 contracts. That means you’re selling the equivalent of calls on 1,000 shares. We don’t want that. We want 100 shares, so you have to make sure the number of calls you’re selling is in-line with the number of shares you bought. That’s why I’m changing it to one: because one lot, or one contract, is equal to 100 shares.
We bought 100 shares, so we want to sell calls on 100 shares. You don’t want to sell too many and see the stock get called away. (For instance, let’s say Intel goes to $40 and you’ve sold 10 contracts on Intel, worth 1,000 shares at $35, which the buyer could exercise. And now you have to come up with those other 900 shares). So it’s got to be the right amount of contracts to cover the shares that you buy. You also always want to do covered calls in lots of 100. If you’re going to buy 100 shares of Intel, you would sell one contract. If you’re buying 500 shares of Intel, you would sell five contracts. And again, we’re selling the call; we’re not buying it. We’re selling it because we’re collecting the money for selling it. It’s adding income for us.
Let’s review: We’re selling one contract of Intel. January 2016 is the expiration date, the strike price is $35 and we want a price of $1.34. Now, again, the price may have moved a little bit. I’m not so worried about this. If it was one of those larger spreads I was talking about, maybe $1.20-$1.50, then maybe we’d put in our price here and specify a price – the minimum amount we would be willing to accept. In this case, I’m fine with trading it at the market because it’s a very tight spread. I hit “confirm” and then “send.” It’s going to tell me the details, and I will get an instant credit of $134.50 if I make this trade. Let’s go ahead and do that.
So we sold it and got filled, raising our account’s cash amount by $134. Simple! We instantly got credited with that $134, and we can do whatever we want with it, though we’re still waiting until expiration. From here, a couple of things could happen… Intel could go much, much higher, in which case we would be forced to sell our stock at $35 when we bought it at roughly $34.74. The option would go to zero if it’s called away, so worst-case scenario would be we miss the upside going up to $40 but still make money.
If Intel goes down (let’s say to $33), we still collect that $1.34 for selling the call. We’ll also still collect the dividend; and at its expiration in January, if the stock is trading at $33, our option is worthless, so it goes to zero. We don’t have to do anything with it, and we can either sell the stock or sell another call: whatever we choose.
Now let me show you the net debit method. That’s a way of doing everything listed above at the same time. That way, you can be sure of the price you’re getting on the entire transaction. Again, we’re going to look up Intel; but now, where it says “spread” instead of “single,” we’re going to go to “covered stock.” Instead of showing the option prices, it now shows the combined price of the stock plus the option. But because you’re selling the call, the option reduces your trade cost.
So basically, you can determine what the option’s price by simply looking at the stock price: the difference between the stock price and the option price. The stock price is $34.74 and the price for the entire trade for a net debit is now $33.31, so the option price is $1.40.
Now, when I give instructions on covered calls in the Dividend Multiplier alerts, I’ll say, “Buy Intel up to $35 and sell the call at $1.35 or higher.” If you’re using the net debit method, the maximum net debit should be $33.50. So you could see it’s trading at $33.29, which is below the maximum net debit. Again, that net debit is merely the stock price minus the amount you’re getting for the covered call. And so the net debit is how much money it’s going to cost you to make the trade. But it’s essentially doing the same thing, just all at once. You still will get that income from selling the call, and you’ll get that immediately.
We’re going to buy the covered stock. That’s how it’s done here. If you’re following along in the video, you’ll see that the default was 10 contracts, or 1,000 shares. We’re going to reduce that to one contract, or 100 shares. And again, you need to check to see that the information is correct: that we are, in fact, selling one $35 January 2016 Intel option contract. We’re buying 100 shares of Intel and the debit is going to be $33.37. I’m going to change this to “the market,” but let’s say I said the limit should be $33.50. You would just come in here and change it to $33.50, and then you would hit “confirm” and “send.”
Since this is a liquid position though, I’m going to change it to “market,” then hit “confirm” and “send.” And again, you’ll see the commissions: how much everything’s going to cost. Hit “send,” and we got filled. Even though we got that $134 in income, it went down because we also bought the stock for $3,470.
From there, you monitor the positions; and when you need to unwind the call, you basically just do the opposite. You would sell the stock and buy back the call. Or if you’re using the net debit method, you would sell the entire position.
That’s pretty much it. If you have any questions, please don’t hesitate to email me at feedback@oxfordclub.com. I know there are going to be plenty of questions, and I will answer them in the Dividend Multiplier alerts. Thanks very much for watching, and be on the lookout for my alerts.