By Mike Parnos of Online Trading*

The Buy-Write

Many covered-call traders are simply selling call options on stock they already own in an attempt to generate a better return on their investment. Others, however, will go out and buy stock specifically for the purpose of selling calls against it.

There are two ways of entering such a position: 1) Place an order to buy the stock. Then, after the stock order is filled, place an order to sell the call option. This is a two-step process and is the one used by most traders -- because it's all they know. However, it may not be the most efficient way.

2) Place an order to buy the stock and sell the option simultaneously for a net debit -- a one-step process. This is called a "buy-write" -- "buying" the stock and "writing" (selling) the call at the same time.

How would we place a buy-write using JNPR as an example? Let's see…

JNPR is trading at $21.27 x $21.33 (bid x ask).

$22.50 option is $1.45 x $1.55 (bid x ask).

As you may know, there is always a spread between the bid and ask prices. The bid / ask spread is where the market maker makes his living. If we want to buy JNPR (or option) immediately, we simply pay what the market maker is asking -- $21.33. The order will be filled instantly.

However, if we want to save a few bucks, we can try to negotiate with the market maker. Instead of paying the $21.33 for the JNPR, perhaps we would offer $21.30 or $21.31. Maybe, he will compromise -- maybe not. If the negotiation attempt order is not filled right away, you take the risk of the JNPR moving up while you're waiting. If it moves up, you may end up paying more than the $21.33, which defeats the purpose of trying to save a nickel or a dime.

If / when your stock order is filled, you may go through the same process trying to fill your order to sell the covered call. If you choose not to negotiate, you won't have this problem. You won't save any money, but you won't have to spend the time and take the risks associated with working the orders.

The buy-write allows you to place the stock and option orders as a single order for a debit limit. More progressive brokers will have screens on their trading platforms that enable you to place these buy-write orders.

Here are two examples of how you might prepare to place a "buy-write" order: a) Buy 1,000 shares of JNPR and sell 10 contracts of JNPR $22.50 calls for a debit of $19.55. This is the debit limit we would use if we did not want to negotiate. It consists of buying at the $21.33 ask on the JNPR shares and accepting the $1.45 bid price on the $22.50 calls.

b) Buy 1,000 shares of JNPR and sell 10 contracts of JNPR $22.50 calls for a debit of $19.80. What we've done here is take the amount we'd like to pay for the JNPR stock ($21.30 / share) and subtract the premium we would like to receive for the $22.50 covered call ($1.50 / share). This figure is our attempt to negotiate a little (approximately $.15) from the bid / ask spreads of the stock and the option.

Now, $.15 may not sound like a lot. But, on 1,000 shares and 10 contracts, it amounts to $150. That's meaningful -- at least to me. It's 150 double cheeseburgers! So, you can initiate a covered call either way. If you're interested in the "buy-write" method, see if your broker has the capability to enter the buy-write. If your broker doesn’t have this capability, you have the wrong one.

The "Covered Call Is Exercised" Alternative

Here's something to consider for those of you who may be selling covered calls on stocks you already own. Some folks are reluctant to sell covered calls on stocks because they are concerned about having the stock called away from them.

They may have purchased the stock a zillion years ago at significantly lower levels, and, if it were called away, there would be substantial capital gain tax implications.

Now, as much as we all LOVE to pay taxes, we don't want to give Uncle Sam any more than we absolutely have to. Agreed? With covered calls, there is some tax-friendly flexibility.

On Monday following expiration, when you are notified that your stock has been called away, there are three days before the transaction settles. All stock sales and purchases settle in three business days.

You have the time to go out onto the open market, purchase an equal amount of stock and designate the newly acquired shares to be the ones to be called away to satisfy the exercising of the covered call.

For instance, if JNPR closed at $24.10 at expiration, and you had sold the $22.50 call, your call would be exercised, and your 1,000 shares of JNPR would be called away. However, if you buy another 1,000 shares at $24.10, you can designate the new 1,000 shares to be the ones called away. That way, you can avoid having to pay a capital gains tax.

The new cost basis of $24.10 would apply to the shares called away -- not the cost basis from the original 1,000 shares at $21.33.

You would have paid $24.10 for the new 1,000 shares, and you would only receive the $22.50 from the covered call you sold. But, you are not out the $1.60. Remember: You still own the original 1,000 JNPR shares -- that have now appreciated by that same $1.60-ish. So, it's a wash -- and you still own the 1,000 JNPR shares.

In the next article (Part 2 of 2, “The Collar of Money”), we'll explore what you can do to avoid the serious downside dangers of the covered calls --and cover your ass-ets. Some of you have heard of it: The strategy is called the "collar."

*Reprinted (and modified) with permission from Mike Parnos of Online Trading Academy (http://www.tradingacademy.com)