Covered Call Writing is considered as one of the safest option trading strategies. The manner in which it is normally described is, that you will buy the underlying shares and then sell call options on them. You can sell them out-of-the-money, at-the-money and even in-the-money, each with different outcomes, determined by current market conditions and anticipations.
Purchasing the underlying shares needs a sizeable sum of capital. If the latest stock price is say, $40 then it will set you back $4,000 to own 100 shares in the usa so that you could write only one call option contract over it. If you wanted to write 10 contracts, the underlying shares would set you back $40,000. Not everybody has that much to put at risk on just one trade.
But what if there was a much more cost effective approach to accomplish exactly the same effect as the covered call, but for a fraction of the cost. Would this appeal to you?
Here is how to do it:
As an alternative for buying the shares themselves, you buy deep-in-the-money call options with at least one year till expiration. These are known as "leap options". By deep-in-the-money we mean the exercise price should be greater than 10 percent of the current market price of the share in-the-money. So in the case of our present example, if the underlying stock price is trading at $40 then we should buy call options at least $4 in-the-money, i.e. with a strike price of $36 or less.
How about we apply a Covered Call Writing worked example.
We have noticed a stock fall to around $40 recently together with significant volume and anticipate that in the near term, it will trade in a range. We could acquire multiples of 100 shares at $40 or on the other hand, we could buy $32 call options with at least twelve months to expiry. Since they’re deep ITM the delta will be very high and most of the value of these options is going to be intrinsic value with very little time value. $32 call options are $8 in-the-money and they cost us $9.40 as opposed to the $40 we would’ve paid for the shares. This means we now have excess funds to buy even more of them or risk less capital.
To buy 10 long call option contracts at this price will cost us $9,400 and not $40,000.
Simultaneously, we also sell 10 at-the-money call options having a strike price of $40 and only one month to expiration. We receive $130 per contract we sell, at total of $1300 income.
Possible covered call writing scenarios at expiry date of the near month options:
- The stock price is below $40.
In this instance the sold options will expire worthless so we keep the $1300. We still hold our $32 call options so now we simply sell more ATM call options for the next month out.
- The share price is slightly above $40.
We can buy back the sold calls and immediately sell further call options for a higher strike price for the next month out, generating a financial gain in the process.
- The share price makes a decisive move upward to about $50
The sold call options will be deep-in-the-money so we will be exposed by $10 per share, which means that we will be obligated to sell the shares at $40 even though market price is $50. BUT while doing so, we also hold $32 call options that now happen to be $18 in-the-money.
So we close out both positions. We make $18 profit, plus some time value, on the $32 options and lose $10 on the sold $40 options, which leaves us a net profit of around $8.75. In addition, we have received a futher $1,300 from selling the $40 call options.
Overall, in one month our covered call writing strategy has produced a gain of $750 (75c x 1000) $1,300 = $2,050 from an investment of $9,400 and that is 21.8 percent for that month.
We then decide whether to buy more deep ITM call options based on the now $50 share price (you need at least $5 in-the-money) and sell near month ATM options again, or proceed to another stock. Our decision will be based on whether we think the future price direction of this share is to remain steady or fall sharply again.
The above mentioned covered call writing strategy is an excellent low risk substitute for the traditional covered call. Your sold options are ‘covered’ by the deep ITM options instead of the underlying shares themselves.
