The Deep-in-the-money Covered Call Options Trading Strategy

There is a variant of the covered call options trading strategy that may have great appeal for safe options sellers. This is the deep-in the-money (DITM) covered call. The major advantage of the DITM covered call is that it offers tremendous downside protection without having to purchase a put collar.

First of all, what is it and why is it different than your plain-vanilla covered call. In a DITM covered call, the strike price of the option sold is far below the purchase price of the stock. You are essentially agreeing to be called out at a much lower price. Why would you do that? You do it only if the premium you receive covers that loss and then some.

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Let’s look at an example: Stock XYZ had been in the $60 to $70 range for years. They announce surprisingly poor earning and they are also hit by a big lawsuit. XYZ drops to $35 over the next two day period. Because of this high volatility, options prices for XYZ have increased in value. The next-month’s 20 call options are selling for $17. If one would enter into this theoretical DITM covered call, the profit would be $200 for each 100 shares. (Here's the math: a $15 loss because you sold at $20 but purchased at $35 BUT a $17 premium received by selling the DITM call. $17 -$15 times 100shares/contract = $200)And look at your downside protection: You are profitable as long as XYZ remains above $18/share!

So what is the downside of the DITM covered call trading strategy? The principal downside is that the profit potential is generally rather low, usually about 5% or less. This is because your profit comes only from the remaining time value of the sold option. You will not be making any additional add-on profit from potential capital gain. Contrast that with a plain-vanilla covered call constructed with an out-of-the-money call: if you are called out you keep the premium plus make a capital gain. Another downside is that profitable DITM covered calls are not always available. Generally, there needs to be quite a bit of volatility in the stock before these opportunities present themselves.

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For some people, DITM covered calls are one of their principal investing strategies. They are particularly appealing for tax-deferred accounts, where the downside protection afforded by this technique is quite attractive. Additionally, the effect of compounding make DITM covered calls a natural for long-term tax-deferred accounts.