October 17, 2003

Money Management Vol. II:
Taking trading costs into account.
By John Brasher, CallWriter Publisher

 

Writers on the subject of trading talk a lot about money management, but few ever talk in detail about managing trade costs. The fact is that trading costs can eat up most, and sometimes all, of your trade profits! The bane of all non-professional traders is commission cost. There is a lot of confusion among inexperienced traders as to how commissions are structured and charged. No subject trading related subject is dearer to our hearts at CallWriter than that of money management. So here is the straight skinny on trading costs.

The Cost of the Trade...

Keep in mind when reading that a number in red indicates a debit, or purchase and one in green indicates a sale, or credit (not necessarily a profit). The colors make it easier to see which transactions are sales and which are buys.

A covered call trade is actually two trade orders (two "legs"), a purchase of stock and sale of call options, and you pay a commission for each leg. If you are called out of a trade, you will pay another commission to sell the stock but will not be charged for the call holder's exercise of the calls. And if you are forced to close the position, you must buy back the call options and sell the stock, which involves yet another two commissions! Let's look at how this works, using the optionsXpress commission structure of $14.95 minimum for an option trade (up to 10 contracts) and $14.95 minimum for a stock trade:

So you will pay $29.90 in commissions to enter the trade, and $14.95 if you are called out (or if the calls expire worthless and you have to sell the stock), for total commissions of approximately $45. If you instead have to close the trade by repurchasing the calls and selling the stock, your commission total is approximately $60. So your best case for trading commissions is $45. And these optionsXpress commissions are the same whether you write one contract or 10! The commission structure is similar at every online options broker: the more contracts you write, the lower the cost per contract. Obviously, trading costs make a difference, and more to the point, the number of contracts you write makes a difference. (Note that in the above table, to open and unwind a covered call trade you would normally never have to pay commissions A, B and C; you would pay either A and B or A and C, but not all three.)

If the cost to run a small covered call trade is $30, then someone writing only one contract is paying $30 for that single contract ($0.30 per share), which offsets premium received. Getting called out of the stock or selling the stock if the calls expire worthless requires another $15 commission, raising costs to $45 so far. And having to exit the trade would raise total commission costs to $60 per contract ($0.60 per share). Obviously, any premium smaller than $0.60 hands this trader a loss if only 1 contract is written and the trade has to be closed.

Here is how to figure commission costs, using the above example:

Trade Tip:  Keep an eye on commission costs. You know that one way or another you will end up selling the underlying stock, whether you are called out or not. So with the above commission structure, you are guaranteed a minimum of $45 in commission cost to complete the trade, and you have to assume your commission costs could be $60. Make sure that your commission costs per share leave you a profit. (It is possible to keep the stock and avoid commission cost under certain circumstances and we will explore those scenarios in a subsequent volume of our Money Management series.)

In Example 2 below, assume that several traders are writing covered calls on a $15 stock and that each writes a 15 call and receives a premium of $1.00 per share ($100 per contract sold). Keep in mind that when the position is established, the stock costs $15 but they each receive $1.00 in premium, so the trade generates a net debit of $14 per share when run. Each trader pays $30 in commissions when the trade is run: $15 to buy the stock and $15 to sell the call or calls. The first three Trade Entry columns compare the costs of entering the trade. The second three Calls Expire columns reflect a scenario in which the calls expire worthless and the stock is sold in the market for $15, the same price originally paid. The third three Close Trade columns reflect a scenario in which the stock declines to $13.50 and it is necessary to buy back the calls at $0.15 and sell the stock at $13.50 to close the trade. Let's explore how they do in different circumstances:

The Calls Expire and Close Trade rows represent alternative scenarios, since only one of them could occur in a single covered call trade.

(1)  The numbers shown in the Trade Entry rows are "premium received " because the trade has at this point just been initiated, and there is as yet no profit. Profit is determined only upon close of the trade. However, it is fair to reflect the profit potential of the trade upon entry, after deducting trade costs.

(2)  The numbers shown in the Calls Expire row reflect are profits upon selling the stock at $15 after the calls expire worthless (without being exercised). The same profit would result from being called out at the $15 strike price, since this was an at-the-money call. This is a final profit number, since the trade is closedby selling the stock. Note the improvement from writing 2 covered call contracts instead of 1, and the dramatic improvement from writing 3 call contracts. Note that if the call expired worthless and the stock was sold for less than $15, either the profits would be lower, or a loss would result.

(3)  In the Close Trade rows, note the dramatic difference in the loss suffered by the trader writing only 1 contract as compared to the trader writing 3 contracts. Writing 5 contracts improved the loss picture even more, but less dramatically than writing only 3. This highlights the detrimental effect of only writing 1 covered call contract. To follow our numbers logic: the stock was purchased at $15, a $1.00 premium was received, but the stock was sold at $13.50 (a $1.50 loss) and the calls had to be repurchased for $0.15, so a net loss of $0.65 was realized on the trade before taking trade costs into account. Total trade costs for both the entry and exit ($0.60 per share for 1 contract, $0.20 per share for 3 contracts and $0.12 per share for 5 contracts) are then added to the $0.65 loss on the trade.

In Example 2 above, what if the premium had been lower, say $0.80 or $0.85 per share, instead of $1.00? The 1-contract trade would have been barely profitable even in the best case.

We hope this explanation of trade commissions and how they affect trade profitability is helpful to you. We at CallWriter, given a choice between running a couple of 1-contract trades or a single trade with multiple contracts, will almost always choose the one trade, because writing multiple contracts lowers trade costs and increases profits. The other choice you should consider if confronted with this choice is to look for cheaper stocks to write. Don't try to write champagne stocks on a beer pocketbook.

Good luck and good trading!