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The In-the-Money Buy-Write is an income producing option trade for situations with currently high Implied Volatility.

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Strategy: Buy-Write, ITM

a.k.a. Covered Call

Buy Write Option Graph

The Outlook: Options currently have a very high IV relative to normal, and you do not expect a dramatic drop in the stock price.

The Trade: Buy stock, sell an ITM call with very high IV.

Gains when: Stock does not fall below the current stock price - option premium.

Maximum Gain: Limited.

Loses when: stock falls below the breakeven price.

Maximum Loss : Unlimited.

Breakeven Calculation: Current stock price - option premium received.

Advantages compared to stock: Takes advantage of stock that does not move or moves within a range.

Disadvantages compared to stock: Limited potential gains, possible large percentage losses.

Volatility: after entry, increasing implied volatility is negative.

Time: after entry, the passage of time is positive.

Margin Requirement : None (same strategy as a Covered Call).

Variations: Using an ATM strike will increase the potential gains, but also raise the breakeven point.

Synthetic Equivalent: Short Put using the same strike price.

Comments

  • This is a trade for special situations, in which the IV is currently at very high levels, you expect the IV to return to normal, and you do not expect a dramatic drop in the stock price. This may be the case when a stock has had a sharp selloff that you do not expect to continue. The intent is to take advantage of the high IV and receive a lot more premium than normal, while still allowing for a good percentage move in the stock either up or down.
  • The trader using this strategy normally expects to be called out of the stock, since he sold a call below the current stock price. The gain is made from the option premium, not stock movement. In the example trade, there may be a good chance of a $191 gain on a $4309 investment in one month, which is a 4.4% monthly gain, or about 53% annualized.
  • The graph for this strategy is the same as the Short Put, OTM. You can use the Buy-Write version if you do not have permission for naked options.
  • The graph of this strategy is the same as the graph of a Covered Call using the same strike price. Normally a Covered Call would not use an ITM strike, because you are practically guaranteeing you will be called out at a very small gain if the IV is normal. You might want to read the Covered Call strategy page and the Covered Call Strategies Disadvantages page if you are considering this strategy.

Exits

  • Since this is a strategy with the potential for relatively small gains and possibly large losses, you must control the losses. If the example stock dropped to $44 or $45 at any time, the trade should probably be exited for a relatively small loss. Trying to hang on could result in much larger losses.
  • Another philosophy if the stock dropped below $45 would be to maintain the position, hoping to realize the entire premium, in this case $691. That would lower your "cost basis" in the stock to $43.09, and if the IV is still high, you could write another ITM call for the next expiration month. This is dangerous, since if the stock falls to $45 there is no rule that says it can't drop much further, and you could lose much more than $691 on a falling stock.
  • If the stock rises or holds steady, and the IV returns to normal, there will be a good gain. The entire position should probably be closed if that happens, to avoid the risk of the stock reversing.

Adjustments

  • If the stock stays near or above the entry price, the short calls will lose value as time passes or if the IV drops back to normal. The entire position can then be closed for a gain.
  • Another option if the trader is now more bullish on the stock is to close out just the short calls for a gain on the options, while still holding the stock for an expected bullish move.
  • If the trader adjusts to just long stock, he can now sell ITM, ATM, or OTM calls against the stock with a later expiration date, depending on just how bullish his opinion now is.

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