Covered Call Boot Camp
Safer Income, Higher Income
The type of call option we’ve discussed so far is called an out-of-the-money call. That
means that the strike price of the option, $19, was higher than the cost of the stock, $18,
at the time the option was purchased. Out-of-the-money options have no intrinsic value to
the buyer at the time of purchase; they just have the potential, or time value, to become
worth something if the underlying stock goes above $19. An option with no intrinsic value
is still given time value by the market. The more time to expiration, the higher the time
value an option will have.
There is another type of covered call you can write besides the out-of-the-money call;
it is called an in-the-money call. If instead of selling a call with a strike price of $19,
you sold one with a strike price of $17 or lower, you’d be selling an in-the-money call on
your $18 stock. "In-the-money" means that the option already has intrinsic value, that is,
the current stock price is higher than the strike price of the option. Naturally, an
in-the-money option is more expensive than an out-of-the-money option of the same duration.
A buyer of these options could immediately exercise the option and sell the stock for a sum
that is above the strike price. However, he probably wouldn’t recover the premium he paid by doing that.
In-the-money options also have time value, since they too have the potential to rise if the underlying stock does.
When an option writer sells an in-the-money call, he expects the call to be exercised.
That is, he expects his underlying stock to be called away. Because he receives a higher absolute
premium on in-the-money calls, his net investment and net risk in the stock is less than it is
when he sells an out-of-the-money call.
Writing in-the-money calls is a more conservative strategy than writing out-of-the-money calls.
When all factors are considered, writing in-the-money calls provides a lower expected return, but
more downside protection than writing out-of-the-money calls. Of course, it is possible and sensible
to blend the two strategies to get the optimum balance of return and risk protection. This is what
we do with our service. We tailor our portfolio of in-the-money and out-of-the-money calls to be
balanced for the amount of risk we see in the market.
To illustrate the difference in the two types of calls further, let’s look at a comparison of the
two trade examples shown above.
Comparing The Types Of Calls We Use
|Original Cost of Stock
|Net cost of stock to option writer
|Return as % of net investment, assuming no stock price movement
|Annualized return on 6 month option
|Percent stock could fall before option writer is losing money
Note that of the $2 premium received for the in-the-money call, $1 will, in effect,
be returned to the option buyer upon exercise of the option, since the seller only
gets $17 for stock that had a net cost of $16. Hence, the out-of-the-money writer does
better in an up market or a sideways market for the stock. The in-the-money writer
has greater protection if the stock falls.
This example is a good, conservative representation of the kind of profits that
can be made while still taking much less risk than the market does. This can help even
the most skittish investor sleep well. Even if in a particular year, the market goes down
the tubes and drags all stocks with it, the call writer in our example has a free lunch on
the first 7% to 11% of trouble. There are few years when the market has losses greater than
that, but even when it does, we can avoid a lot of trouble. Since we seldom write calls
more than 6 months out, we have the ability to get to the sidelines before much damage
is done. In fact, we usually write calls with expirations of only 3 or 4 months. They
provide the most profit and protection for our purposes.
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