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Strategy: Covered Call, ITM

a.k.a. Buy-Write

Covered Call In the Money Option Graph

The Outlook: Mildly bearish to bullish. The position will gain if the stock rises, stays put, or falls somewhat.

The Trade: Sell an ITM call against owned stock.

Gains when: Stock does not fall below the stock price at entry - the credit received.

Maximum Gain: Limited.

Loses when: stock falls beyond the breakeven price.

Maximum Loss : Unlimited.

Breakeven Calculation: Stock price at entry - option credit.

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

Disadvantages compared to stock: Very limited potential gains.

Volatility: after entry, increasing implied volatility is negative.

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

Margin Requirement : None, but stock ownership must be maintained.

Variations: Using an ATM strike will bring in a larger credit, but raise the breakeven point as well.

Synthetic Equivalent: Short Put at the same strike price.

Comments

  • The Covered Call using an ITM strike normally does not make much sense. You are spending a lot to buy stock, taking in a very small premium, and have a greatly increased chance of being called out of the stock.
  • However, if you are already a stock owner, want to own the stock for the long term, but feel the stock is going to drop in the near term, this could be a way to protect against a limited loss without spending anything to buy a put. The example stock could drop from $50 to $44.61 for instance, and your overall equity would not change much.
  • There are always tradeoffs, however. If the stock were to rise after you sold the ITM call, it would get expensive to buy it back in order to avoid being called out of your stock. In effect, you would give up any increase from the stock price.
  • A different philosophy for this same strategy can be used when you do not already own the stock, the Implied Volatility is very high, and you do not expect a large drop in the stock price. See the Buy-Write, ITM for details.

Exits

  • Since this is a strategy with the potential for only small gains and possibly large losses, you must control the losses. If the example stock dropped to $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.

Adjustments

  • If the short calls lose most of their value at any time, the calls can be bought back for a small gain, to avoid the risk of the stock rising.
  • If your outlook for the stock becomes more bullish, you can roll the ITM calls to either ATM or OTM calls expiring in a later month.
  • Or if your outlook is much more bullish, you should buy back the short calls at any price, since they will only get more and more expensive to buy back if the stock continues to rise.

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