Writing in-the-money calls is a good strategy to use if the options trader is looking to earn a consistent moderate rate of return.
|Covered Call (ITM) Construction|
|Long 100 Shares|
Sell 1 ITM Call
Offers more downside protection as premiums collected are higher than writing out-of-the-money calls.
As the striking price is lower than the price paid for the underlying stock, any upward price movement will not benefit the call writer since he has agreed to sell the shares to the option holder at the lower striking price. Therefore, the maximum gain to be made writing in-the-money calls is limited to the time value of the premium at the time of writing the call.
The formula for calculating maximum profit is given below:
As the premiums received upon writing in-the-money calls is higher than writing out-of-the-money calls, downside protection is greater as the higher premium can better offset the paper loss should the stock price go down.
The formula for calculating loss is given below:
The underlier price at which break-even is achieved for the covered call (itm) position can be calculated using the following formula.
Suppose the stock XYZ is currently trading at $50 in June. An options trader decides to write a JUL 45 covered call for $7. He pays $5000 for the 100 shares of XYZ and receives $700 in premium giving a net investment of $4300.
The stock then rallies to $55 at expiration and the call gets assigned. As per the options contract, the trader has to sell the 100 shares of XYZ at the striking price of $45 and so he receives $4500 for the shares sold. Since his original investment is $4300, his net profit for the entire trade is only $200.
However, should the stock price go down to $45 instead, he still makes a profit since the $700 in premiums received more than offset the $500 in paper loss of the 100 shares he held which has lost $5 a share in value.
At $45, the call most likely will not get assigned since there is no intrinsic value left in the option. Since the shares did not get called away, the call writer can either sell the shares for $4500 giving him a net profit of $200 for the entire trade or write another call against the shares held.
For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.
However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).
The following strategies are similar to the covered call (itm) in that they are also bullish strategies that have limited profit potential and unlimited risk.
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