As you can see in Figure 1, the most attractive feature of the writing approach is the downside protection of 38% (for the May 25 write). The stock can fall 38% and still not have a loss, and there is no risk on the upside. Covered Call Income Generated from Retire Corp. 1. This is because the entire position can be entered into based on the optimal income initially. Alex’s annualized return on this in the money covered call strategy would be: Option Net Profit/Cost of Retire Corp$ .90/18.50 = .049 x 12=59% annualized. But the good thing is that Alex gets to keep the $ 1.40 for selling the option, which reduces her Retire Corp position cost per share cost to $17.10. A fence is a defensive options strategy that an investor deploys to protect an owned holding from a price decline, at the cost of potential profits. A collar, commonly known as a hedge wrapper, is an options strategy implemented to protect against large losses, but it also limits large gains. After a covered call is exercised, the capital used to own the stock is available for new covered call positions. The near … Nevertheless, covered call strategies work best and are the easiest to implement in sideways or upwardly trending markets. Because 90% of traders who buy options without having an edge lose money. And, of course, covered calls can be sold on etf’s of other asset classes that often move counter to stocks, such as bonds, or sometimes gold. Alex can sell a call option for two or more months out, increasing the option premium by increasing the time value. One of 3 things could happen at option expiration as outlined below. This was the case with our Rambus example. Of course, there is no way to know this with certainty but the stock chart can provide probabilities. ♦Income Stream Tip♦  Selling call options on high dividend stocks can make sense for investors who always want at least a little income from stocks. This post goes into more detail ahead, outlining the income, three different outcomes, and potential actions at option expiration for a specific in the money covered call strategy so keep reading. ♦Wealth Building Tip♦ All investments are bad if they take an investor outside of acceptable risk while too little risk can hinder investment returns. Option premiums were higher than normal due to uncertainty surrounding legal issues and a recent earnings announcement. Instead of selling another call option right after option expiration, Alex can watch the stock chart with the plan to sell a call option near the top of the current trading range to get a higher option premium. Hire a financial professional if you think you need one. Let’s look at the third possible outcome at option expiration with her Retire Corp in the money covered call strategy. A zero cost collar is an options strategy used to lock in a gain by buying an out-of-the-money (OTM) put and selling a same-priced OTM call. Proposed strategy. price since the option prices have declined with the stock price. income while reducing or eliminating capital gains. Get my free eBook with our top 9 strategies to build wealth while generating income. excluded from the calculations in this post. Sell a deep in-the-money strike with a 2% time value premium and downside protection of that profit; … They are addicted to the thrill of the game as they continue to look for that next explosive trade. This occurs with out of the money covered call strategies but not with in the money covered call strategies. – Buying an in the money LEAPS call – Selling an out of the money call with a near-term expiration date. If you can live with less downside risk and you sold the May 30 call instead, the potential return rises to +9.5% (or +131% annualized) - or higher if executed with a margined account. The strategy I implement with my deep in-the-money calls is to buy with a strike date four to seven months in the future in order to provide leverage and downside protection over a long period … It’s a fool’s errand. And, of course, some stocks do well during bear markets. For further reading, see Come One, Come All - Covered Calls. Books about option trading have always presented the popular strategy known as the covered-call write as standard fare. This is simply because when an in the money covered call is exercised, the option seller has to sell the stock at a lower (strike) price with an in the money covered call than an out of the money covered call. with our favorite 9 income generating strategies that build wealth, too. Note that if you’re new to stock charts, while technical analysis can seem daunting, very basic technical analysis can be an incredibly valuable tool for evaluating the best covered call strategies. Otherwise, I’d sell an out of the money covered call. Again, this means that in the money covered call strategies generate higher income than out of the money covered call strategies. You’ll want to decide if you prefer that your covered calls get exercised or not. who are already exposed to stock market risk anyway. It closed at $17.16. This allows you to sell call options repeatedly against the same stock position, thereby reducing the need to find additional suitable stocks. (Pardon the irresistible pun.). These conditions appear occasionally in the option markets, and finding them systematically requires screening. because when an in the money covered call is exercised, the option seller. Option 2. Based on your overall wealth plan, you may find that you want income more than capital gains. This article is going to cover selling deep in the money (ITM) puts. or out of the money covered call strategy. This would be offset by a loss on the stock of $300 ($.50 per share assuming she sold it at $18 on Monday morning following option expiration) leaving her with a profit of $500. Your email address will not be published. Additionally, many investors sell covered calls in IRA’s to eliminate, defer or reduce taxes. If you hate managing covered calls, in the money strategies may be best for you since more in the money covered call positions get exercised than at the money or out of the money covered call strategies. If we were going to do a traditional covered-call write on RMBS, we would buy 100 shares of the stock and pay $3,860, and then sell an at-the-money or out-of-the-money call option. It makes more sense—instead of buying 500 shares of ABC stock at $60 (for $30,000)—to buy five of the ABC Jan 45 calls … If you think a stock is headed down, as was the case in the example above with Ali’s stock, selling an in the money call option can be the best strategy. However, for retirees and others living off investments who count on covered calls for income, bear markets can present a real challenge. Put selling by using deep in the money puts is a … When this happens, unfortunately, all your covered call capital gets tied up in those covered call stocks that didn’t get exercised! Selling deep in the money puts is an exceptional strategy that pays enormous dividends and has distinct advantages over buying stock and waiting for it to rise. Read my related posts: Are Covered Calls a Good Idea? By using Investopedia, you accept our. Selling in the money covered calls can be an excellent income generating strategy for those living off investments. (Read my related post What Goes Up When Stocks Go Down?). ♣  It’s super important to remember that when you sell in the money covered calls, you know that you may have to sell the stock at a loss. Also remember that bear markets have, in hindsight, usually been excellent opportunities for covered call strategies once a sideways or bull market resumes. market price when she sold an in the money call option for $1.40 with an $18 strike. As you can see, all the profit from this covered call investment came from the sale of the option premium, as is often the case with in the money covered call strategies. While it’s not completely under your control whether a call option gets exercised, the covered call strategy used will definitely affect the probability that positions will get called at option expiration. The offers that appear in this table are from partnerships from which Investopedia receives compensation. Note that many covered call writers prefer to open new positions every 4 to 6 weeks for minimal effort with good income, but there are many other covered call time frames, including weekly options, how much time you want to spend on your income streams, and wealth building strategies from your lifestyle, Like Ali, you may have checked a stock chart and seen that the stock is at the high end of the recent trading range, f you’re new to stock charts, while technical analysis can seem daunting, v. ery basic technical analysis can be an incredibly valuable tool for evaluating the best covered call strategies. Remember, the higher income trade off with in the money covered call strategies is that the stock can be called at a loss. set to significantly lower stock risk when selling covered calls. An in the money covered call strategy involves selling a call option with a strike price lower than the cost of the underlying stock. Also remember that bear markets have, in hindsight, usually been. It’s easy for investors to get lured into writing covered calls because the income is so high relative to dividends. If you’re interested in creating diversified income streams and investing strategies other than passive stock and bond portfolios, you’re in the right place; this site is about our (mine and hubby’s) journey to financial independence following our late midlife epiphany that we needed to make some shifts in the way we were investing if we wanted funds for life. ♦In My Experience♦ I usually enter in the money covered call strategies, however, with the expectation that the stock will temporarily decrease in value. Keep in mind this is income from one month’s profit from just one covered call position. You can see why covered calls can be a great income generator for stock investors who are already exposed to stock market risk anyway. All you have to do is to write ( sell to open) 1 contract of deep in the money call option for every 100 shares you own. The primary risk in this strategy is that the underlying stock may move further downward. As you can see in Figure 2, with the May 25 in-the-money call write, the potential return on this strategy is +5% (maximum). Let’s say that Ali buys 100 shares of stock in Income Streams, Inc, for $100. Our Income Stream, Wealth Building Adventure Later in Life. Investopedia uses cookies to provide you with a great user experience. ♦Income Stream Tip♦  To understand why covered calls can be an excellent income generating strategy for those living off investments, compare covered call income to typical stock dividend income. Read Trade The Covered Call - Without The Stock.). And since the market is declining, it is harder to sell call options near your stock purchase price since the option prices have declined with the stock price. If you enjoy researching stocks and easily find new ideas for covered calls, you may want all your covered call positions to get exercised so you can enter new positions more often. (Find out about another approach to trading covered call. Alex can watch the stock chart with the plan to sell a call option near the top of the current trading range to get a higher option premium. One last advantage for in the money covered call strategies is that having all your covered calls exercised each month provides capital for fresh positions without having to allocate more capital to stocks designated for covered calls. RMBS closed that day at 38.60, and there were 27 days left in the May options cycle (calendar days to expiration). The option buyer could simply buy the stock for less than the strike price of $18 so there would have been no reason to exercise the option. We can begin by looking at the prices of May call options for RMBS, which were taken after the close of trading on April 21, 2006. Alternatively, you may have an insight into an upcoming event, such as company earnings or a new competitive product, that will likely cause the stock to drop, ideally on a temporary basis only. In this case, Alex would have made $800 from selling the call options. Why? makes more sense to sell in the money covered calls than. But there is very little downside protection, and a strategy constructed this way really operates more like a long stock position than a premium collection strategy. ♦Risk Management Tip♦  All investors will want to confirm that investing in stocks is within their own acceptable risk level before even considering using any covered call strategies. Alex can sell another call option for the next month against her shares in Retire Corp. ince the stock price has dropped from her purchase price of $18.50. and Stocks That Went Up in 2008 or What Goes Up When Stocks Go Down? In the money covered calls, however, tend to be the least risky of the three covered call strategies, and here’s why: In the money strategies offset stock cost more than other covered call strategies because the covered call writer gets the highest premium when selling in the money options, as explained ahead. stick with me because it’s important because it makes the math on in the money covered call strategies easy to understand. Why? ♦Wealth Building Mindset♦ Always evaluate potential best and worst case investment outcomes, then accept and learn from what occurs. My Ultimate RISE Wealth Plan is the best place to begin if you’re interested in designing your own unique, slightly alternative plan to live well for life...Be forewarned; it’s not for the faint of heart. Now a deep in the money option usually has a delta of .60 or above meaning that the option will move $.60 cents for every dollar move in the underlying stock. for more on covered call risk. So, "deep in the money" call options would be calls where the strike price is at least … Like Ali, you may have checked a stock chart and seen that the stock is at the high end of the recent trading range. The option buyer didn’t exercise the option since the market price of the stock on expiration day is below the strike price. Assume the option buyer did not exercise the option by buying the stock. As you can see in Figure 1, it would be possible to sell a May 55 call for $2.45 ($245) against 100 shares of stock. There is a trade off for this income, however, and more to consider as explained below. Stock Closes at the Strike Price on Options Expiration, 3. By using a DITM strategy, you can accomplish several things: Lower your cost of entry into a stock that … Read my related post Problems with Covered Calls. * ABC Jan 50 calls trading at $15 (These are in the money by two strike prices.) Most investors just assume selling covered calls is risky since it involves options. They should be considered based on your own situation and commission structure. This is because the cost basis is much lower due to the collection of $1,480 in option premium with the sale of the May 25 in-the-money call option. Before deciding whether to use an out of the money, at the money, or an in the money covered call strategy, consider the above factors, overall stock market direction and your own financial goals for building wealth or income. Required fields are marked *. Selling deep in-the-money call options represents an innovative approach to obtaining high probability yields. Likewise, new covered call trades each month tend to generate more income, easier. aving all your covered calls exercised each month provides capital for fresh positions, without having to allocate more capital to stocks designated for covered calls. is that stock and option commissions have gotten very cheap over the past two decades due to competition, especially with the ability to buy and sell securities online. Now that you’ve seen the factors to consider before choosing an in the money covered call strategy specifically, let’s look at the math with an example. Traditional Covered-Call Write Let's look at an example using Rambus (RMBS), a company that manufactures and licenses chip interface technologies. (To learn more about covered-call strategies, read Covered Call Strategies For A Falling Market.). * ABC Jan 45 calls trading at $18.50 (These are in the money by three strike prices.) Read my related post to see how a stock market crash will affect you. This exact discovery led us to, create diversified multiple income streams. Stock Closes Out of the Money on Option Expiration, Lowering Stock Risk with In the Money Covered Calls, The stock price is expected to decrease near term, The call seller wants the option to be exercised. You can then sell the underlying stock, buy back the short calls … Risk is permanently reduced by the amount of premium received. Again, it’s important to first note that investors who own stocks without covered calls, especially stocks that don’t pay dividends, also suffer during bear markets. Also, the potential rate of return is higher than it might appear at first blush. Some of our members have inquired about using deep in-the-money puts (strike well above current market value) instead of out-of-the-money … While in the money covered call strategies may do best in declining stock markets, out of the money covered calls aren’t ideal either on declining stocks or etf’s. While I’m an AFC, I mostly write based on my 40 year investing adventure; I don’t manage wealth for others although I have hired a few financial advisors over the years. How Does an In the Money Covered Call Strategy Work? This exact discovery led us to create diversified multiple income streams over the past 15 years from real estate, stocks, and online business. While it’s not completely under your control whether a call option gets exercised, the covered call strategy used will definitely affect the probability that positions will get, If you hate managing covered calls, in the money strategies may be best for you since mo, in the money covered call positions get exercised, than at the money or out of the money covered call strategies, This is simply because the strike price is lower with an in the money covered call strategy than it is with an at. This is offset, however, by the reality that managing unexercised covered calls doesn’t generate as much income as new monthly trades. Plus, … Either way, Alex kept the $800 from the option sale. When found, an in-the-money covered-call write provides an excellent, delta neutral, time premium collection approach - one that offers greater downside protection and, therefore, wider potential profit zone, than the traditional at- or out-of-the-money covered writes. Trade deep in-the-money calls to increase yield on a stock and lower the downside risk. Everyone knows what deep in the money calls means. They should be considered based on your own situation and commission structure. . She will keep the stock, with the plan to sell another call option soon at an opportune time, anticipating the stock will move back toward the high end of its’ trading range within a week or two based on the stock’s recent trends. If you write/sell deep in-the-money calls on stocks you have owned for more than one year, a long-term gain turns into a higher taxed short-term gain. If the overall market is trending down, however, it usually makes more sense to sell in the money covered calls than out of the money covered calls as explained below, IF you choose to stay invested in stocks despite the decline. first covered call on a new position has the best return, over ongoing, managed positions, giving me a bias toward at the money or in the money covered calls. That’s not to imply covered call strategies are bad. sell covered calls in IRA’s to eliminate, defer or reduce taxes. Alternative Covered Call Construction As you can see in Figure 1, we could move into the money for options to sell, if we can find time premium on the deep in-the-money options. Ali already made a nice $2 per contract for the call option she sold. the money covered calls as explained below, Out of the Money Vs In the Money Covered Calls in Bear Markets, income generated since the option premium (price) gets lower as it moves further up and away from the stock price, Second, if you’re selling out of the money covered calls, ince the market is declining, it is harder to sell call options near your stock. Figure 1 - RMBS May option prices with the May 25 in-the-money call option and downside protection highlighted. But there is another version of the covered-call write that you may not know about. Your email address will not be published. After a covered call is exercised, the capital used to own the stock is available for new covered call positions. The six-month (December) deep-in-the-money 1050 call is now trading for $131, meaning you can initiate the long side of the trade for $13,100 instead of $115,500. As you may have guessed, selling covered calls is one of them! brokerage account for the sale of the option, generating strategy for those living off investments, c. 00 covered call income is from the following calculation: How Many Stocks Does One Option Contract Represent? Selling call options against shares you already hold brings in guaranteed money right away. The, Higher Income from In the Money Covered Calls. Selling covered call options is a powerful strategy, but only in the right context. An option is said to be "deep in the money" if it is in the money by more than $10. Since in the money covered calls are more likely to get exercised as stocks drop, they are generally a better choice than in the money covered call strategies in declining markets. Again this is where deep in the money calls as a strategy for bear markets can be a winning strategy. This is because the call option income offsets the cost of the stock the minute the call option income hits your brokerage account. Note that since the stock price has dropped from her purchase price of $18.50, the income generated will not be as good as the prior month since the stock price (and related option) is lower. The question presented was the following strategy, a “can’t-lose” approach to covered call writing? Alex bought 600 shares of Retire Corp for $18.50 a share on May 16. What Happens at Options Expiration for in the Money Covered Calls? Looking at another example, a May 30 in-the-money call would yield a higher potential profit than the May 25. Read my related post on the cash allocation in a portfolio. The maximum return potential at the strike by expiration is 52.1%. This means if Alex sells another covered call it will probably not be in the money since doing so would generate too much of a stock loss. This is calculated based on taking the premium received ($120) and dividing it by the cost basis ($2,380), which yields +5%. And, of course, some stocks do well during bear markets. Therefore, we have a very wide potential profit zone extended to as low as 23.80 ($14.80 below the stock price). Likewise, offset, however, by the reality that managing unexercised covered calls, doesn’t generate as much income as new monthly trades. You’re betting for a specific outcome … Unless Alex buys back the call option, what happens on options expiration depends on the price of the stock on June 15, the third Friday in June that year, so let’s look at that next. The worse thing for covered call writing is, bear markets so let’s see how bear markets affect in the money covered call strategies when compared to other covered call strategies. If used with margin to open a position of this type, returns have the potential to be much higher, but of course with additional risk. In this case, the option buyer may or may not “exercise” the call option (buy the shares of Retire Corp) since the option strike price is the same as the market price on option expiration. Now that risk from covered call strategies has been addressed, and how in the money covered calls can be the least risky strategy, lets’ see how an in the money covered call strategy, specifically, works, as opposed to other covered call strategies. I like to assess this from a stock chart, as well as fundamentals such as earnings and dividends, while also factoring in the risk I am willing to accept. That's over three times what highly rated bonds pay. before even considering using any covered call strategies. Clearly, the risk/reward seems misplaced. An in the money covered call strategy involves selling a call option with a strike price lower than the cost of the underlying stock. Ali’s example gives you a basic and broad idea of why a covered call seller may choose an in the money covered call strategy. An in the money covered call strategy usually generates higher income while reducing or eliminating capital gains. This traditional write has upside profit potential up to the strike price, plus the premium collected by selling the option. If increasing stock income by selling covered calls is the primary objective, it’s worth considering in the money covered call strategies. Figure 2 - RMBS May 25 in-the-money call write profit/loss. My experience has been that usually the very first covered call on a new position has the best return over ongoing, managed positions, giving me a bias toward at the money or in the money covered calls. Again, it’s important to first note that investors who own stocks without covered calls, especially stocks that don’t pay dividends, also suffer during bear markets. 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. For options, both a call and a put option can be in the money. Now back to Alex and her covered call position on Retire Corp. The formula for calculating maximum profit is given below: Investment capital allocated to covered call selling can get completely tied up with little if any income from stocks during bear markets. So, by owning 600 shares of Retire Corp, Alex was able to sell the 6 option contracts. Sell a Call Option After Stock Rises. price with an in the money covered call than an out of the money covered call. And then the game is over. ers living off investments who count on covered calls for income, bear markets can present a real challenge. Here is an example of an in the money covered call strategy. On that strike, there is $260 in time premium available. At the time these prices were taken, RMBS was one of the best available stocks to write calls against, based on a screen for covered calls done after the close of trading. DISCLAIMER: Nothing in this post is meant to be taken as personal financial advice. Summary for In the Money Covered Call Strategy. Stop losses can be set to significantly lower stock risk when selling covered calls. that will likely cause the stock to drop, ideally on a temporary basis only. On the other hand, managing covered calls is probably a little less work than finding new covered calls to sell every month. It’s a fool’s errand. This is why I often write that selling covered calls can be an ideal income stream for investors who already have stock market risk in their portfolio anyway. you may have an insight into an upcoming event. One of the most popular short trading methods is selling out-of-the-money … The Bottom LineCovered-call writing has become a very popular strategy among option traders, but an alternative construction of this premium collection strategy exists in the form of an in-the-money covered write, which is possible when you find stocks with high implied volatility in their option prices. Wide potential profit than the cost of the underlying stock, buy back the short call extremely... $ 260 in time premium available all - covered calls for income, bear can! Of Retire Corp strategies for a period of just 27 days an out of the money calls.... 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