At-The-Money and In-The-Money Covered Call Writes
At-the-money and In-the-money covered call writes can be some of the most effective types of covered calls techniques to use. It’s a little different than the covered call technique that is most often used, that is writing an out-of-the-money call against a stock you own. In this case we will be looking for an option with a strike price that is equal to or slightly below the current price of the underlying. Let’s examine the characteristics of this type of covered call. First, because the option is at-the money or in-the-money, the premium we will receive by selling the call will be greater than for an out-of-the-money call. Therefore, we will receive more money up front. Second, an at-the-money or in-the-money covered call will give us more downside protection, should the underlying decrease in value, than an out-of-the-money play. All this sounds great. Is there any downside? Maybe: As long as the underlying stays at or above the strike price you can be called out. As you know, being called out is not necessarily a bad thing. As long as you have a built-in up-front profit, if you are called out you make money and that is good. But, the profit margins can be slim with this type of covered call write. That is because if you are called out you will be selling the underlying for less than you payed for it. This, of course, will be more than compensated for by the premium received. Let’s look at an example: BBY is selling at $35.50/share and you consider this to be an attractive price. You are skittish on the stock, however, because it has just announced an earnings miss. You decide to buy BBY at $35.50 and immediately sell a front-month 35 call for $0.90. Notice this call is in-the money. As the math tells us, if you are called out you will lose $0.50/share but this will be more than offset by the $0.90 premium received. You would retain a net $0.40/share or $40.00 per contact (before commissions) if called out. If BBY continues to fall below 35 and stays there until expiration day, you will retain the full premium of $90/contract (before commissions) and still hold the stock. You are free to write additional calls if you see fit. The trick with at-the-money and in-the-money covered calls is to make sure the premium you receive offsets the loss on the underling such that you are comfortable with the size of the profit if called out. When you are skittish about the market or the underlying issue you are working with, then you may be more willing to accept a relatively small profit because of the considerable downside protection you get. Over many years, a series of small profits can really add up. Consequently, many people place at-the money and in-the-money covered calls writes in their IRA or other retirement accounts.
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