An Alternative Covered Call Options Trading Strategy

By John Summa AAA

Books about option trading have always presented the popular strategy known as the covered-call write as standard fare. But there is another version of the covered-call write that you may not know about. It involves writing (selling) in-the-money covered calls, and it offers traders two major advantages: much greater downside protection and a much larger potential profit range. Read on to find out how this strategy works.

TUTORIAL: Option Spread Strategies

Traditional Covered-Call Write
Let's look at an example using Rambus (RMBS), a company that 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). (To learn more about covered-call strategies, read Covered Call Strategies For A Falling Market.)

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.

Option Prices:  In-the-money call option and downside protection
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). (Find out about another approach to trading covered call. Read Trade The Covered Call - Without The Stock.)

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.

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

The Bottom Line
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.

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