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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

  Out-of-the-Money Call In-the-Money Call
Original Cost of Stock $18.00 $18.00
Strike Price $19.00 $17.00
Premium Received $1.30 $2.00
Net cost of stock to option writer $16.70 $16.00
Return as % of net investment, assuming no stock price movement 7.2% 6.25%
Annualized return on 6 month option 15.6% 12.5%
Percent stock could fall before option writer is losing money 7.2% 11.1%

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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