An Alternative Covered Call Options Trading Strategy

manufactures and licenses chip interface technologies. 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. RMBS closed that day at 38.60, and there were 27 days left in the May options cycle (calendar days to expiration). Option premiums were higher than normal due to uncertainty surrounding legal issues and a recent earnings announcement. 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. The short call is covered by the long stock (100 shares is the required number of shares when one call is exercised).

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. 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. This traditional write has upside profit potential up to the strike price, plus the premium collected by selling the option.

Figure 1 - RMBS May option prices with the May 25 in-the-money call option and downside protection highlighted.

The maximum return potential at the strike by expiration is 52.1%. 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. Downside protection from the sold call offers only 6% of cushion, after which the stock position can experience un-hedged losses from further declines. Clearly, the risk/reward seems misplaced.

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. Looking at the May 25 strike, which is in-the-money by $13.60 (intrinsic value), we see that there is some decent time premium available for selling. The May 25 call has $1.20 ($120) in time premium (bid price premium) value. In other words, if we sold the May 25, we would collect $120 in time premium (our maximum potential profit).

Looking at another example, a May 30 in-the-money call would yield a higher potential profit than the May 25. On that strike, there is $260 in time premium available.

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. Therefore, we have a very wide potential profit zone extended to as low as 23.80 ($14.80 below the stock price). Any upside move produces a profit.

While there is less potential profit with this approach compared to the example of a traditional out-of-the-money call write given above, an in-the-money call write does offer a near delta neutral, pure time premium collection approach due to the high delta value on the in-the-money call option (very close to 100). While there is no room to profit from the movement of the stock, it is possible to profit regardless of the direction of the stock, since it is only decay of time premium that is the source of potential profit.

Also, the potential rate of return is higher than it might appear at first blush. 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.

Potential Return on In-the-Money Call Writes
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). This is calculated based on taking the premium received ($120) and dividing it by the cost basis ($2,380), which yields +5%. That may not sound like much, but recall that this is for a period of just 27 days. 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. If we were to annualize this strategy and do in-the-money call writes regularly on stocks screened from the total population of potential covered call writes, the potential return comes in at +69%. 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.

Figure 2 - RMBS May 25 in-the-money call write profit/loss.

Conclusion
Covered 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. This was the case with our Rambus example. These conditions appear occasionally in the option markets, and finding them systematically requires screening. 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.

For further reading, see Come One, Come All - Covered Calls.

by John Summa (Contact Author | Biography)

John Summa, Ph.D., is the founder and president of OptionsNerd.com LLC, and TradingAgainstTheCrowd.com. He co-authored "Options on Futures: New Trading Strategies and Options on Futures Workbook" (2001). He is also the author of "Trading Against The Crowd: Profiting From Fear and Greed in Stock, Futures and Options Markets" (2004), which presents contrarian sentiment trading indicators and trading systems for stocks, futures and options. Summa is also co-authoring a book on hedging employee stock options, which will be published in late 2009.

Founded in 1998, OptionsNerd.com provides professional training and educational support to stock, options and futures traders. Summa is an economist, author, options trader and former professional skier, and he presents small-group, online and in-person training seminars. Visit OptionsNerd.com or TradingAgainstTheCrowd.com for more information.