When writing a covered call, what's the difference between a "net debit" and a "net credit"?

Question

My brokerage account (Fidelity) gives me two choices when writing a covered call: net debit and net credit. What's the difference between these two choices?

For example, take DRRX (share price $1.4). I can buy/write to open a covered call position by buying 100 shares of DRRX and writing one call option. If the net debit case, the max gain is $109.00:

but in the net credit case, the max gain is much higher:

What's the difference between these two choices?

Answer 1

When you enter into a multi-legged trade where one is a buy and one is a sell, the limit is expressed as either:

1. A "net credit" - the minimum you need to collect to do the whole thing, or
2. A "net debit" - the most you'd pay to do the whole thing.

The gist is that you don't care what each individual piece costs; you only care what the cost of the bundle is.

When you put on a buy-write, you are buying stock and selling a (covered) call against that stock. That trade will always cost money.

Putting on a buy-write will always be done at a net debit. This is because is is normally impossible for a call to be worth more than its underlying stock price.

There are a few possible reasons there would be a"net credit" option for what's described as a "buy-write":

1. They allow both putting it on AND taking it off on that screen. So, if you were selling the stock (long) and buying the call back (to close), you'd generally expect a net credit.
2. The options are double checking you know what you're doing: If you pick the wrong one, it's a clue that you may have an error in a leg above that it'll prompt you to correct.
3. The software isn't that smart. (I doubt this one - errors are time consuming, and fidelity has been in online trading of options a long time).
4. They need to cover weird edge cases. You'll basically never be able to put on the buy-write (buying stock and selling call) for a credit, but there are rare cases where you might have to do the unwind (selling stock and buying the call back) at a debit, although they are very rare. An example would be that the stock is essentially worthless, but the options are still trading, and have wide bid-offer spreads. So, you have to sell the stock for a penny, but the option quote is 0.00 - 0.10, meaning you'd have to pay 0.09 to do the unwind. Again, this is quite rare.

Answer 2

I am not familiar with this broker, but I believe this is what is going on: When entering combination orders (in this case the purchase of stocks and the writing of a call), it does not make sense to set a limit price on the two "legs" of the order separately. In that case it may be possible that one order gets executed, but the other not, for example. Instead you can specify the total amount you are willing to pay (net debit) or receive (net credit) per item. For this particular choice of a "buy and write" strategy, a net credit does not make sense as JoeTaxpayer has explained. Hence if you would choose this option, the order would never get executed. For some combinations of options it does make sense however.

It is perhaps also good to see where the max gain numbers come from. In the first case, the gain would be maximal if the stock rises to the strike of the call or higher. In that case you would be payed out $2,50 * 100 = $250, but you have paid $1,41*100 for the combination, hence this leaves a profit of $109 (disregarding transaction fees). In the other case you would have been paid $1,41 for the position. Hence in that case the total profit would be ($1,41+$2,50)*100 = $391. But as said, such an order would not be executed.

By the way, note that in your screenshot the bid is at 0, so writing a call would not earn you anything at all.

Answer 3

When you buy a stock and sell a covered call, the call can't be valued higher than the stock, right? How can a call on a $10 stock sell for more than the stock?

So, the initial position of a covered call will cost you something. The transaction is a debit to you. The net amount of the deal, usually prices as per stock/option single share.

For the image showing net credit, it's as if you expect to get paid for you to take this deal.