In An Alternative Covered Call Options Trading Strategy, we examined how to use in-the-money (ITM) covered calls to scalp time premium, and demonstrated why selling intrinsic, as well as time premium, makes for a better covered call strategy. If the stock drops once into your position, for example, you have a much larger downside zone of potential profit as a result of being short intrinsic as well as time premium. In other words, the short ITM covered call offsets losses to a much lower price on your long stock position, than the traditional covered write.
See: What Is Option Moneyness?
Traditional covered call writes offer little downside protection - no more than the time premium collected on the sold at- or out-of-the-money call. So what happens if the stock tanks while using an ITM covered call? Is there a way to build even greater prospects for success into this alternative approach? In this article, we'll look at a recent example of the basic setup of the ITM covered call and illustrate how the addition of one more leg in the trade can provide an added measure of protection.
Containing Downside Damage
Unfortunately, there is no way to eliminate all risk in trading. That said, there are a few other techniques that can be very effective at containing downside damage in these types of trades and can even provide, under certain conditions, the potential for large additional gains beyond the scalping of the time premium on the ITM covered call option originally sold.
After screening for a stock with a high implied volatility - a prerequisite for this type of trade - a number of candidates appear. On June 9, Kinetic Concepts Inc. (KCI) was trading with levels of implied volatility at relative extremes, as seen in Figure 1, below. The company is a global medical technology company in the business of advanced wound care and therapeutic surfaces, and it has a stock rating of 2.2 (with 1 being the best, less than 3 is considered favorable) and a market capitalization of $3.09 billion (look for a minimum market capitalization of $1 billion). (For more insight, check out The ABCs Of Option Volatility.)
When implied volatility is high, time premium on all options will be very "fat," making it a good time to sell options - provided you have a solid strategy for handling any associated potential risk.
By selling options with an inflated time premium, you are establishing a position with a large positive Theta (a fast rate of time value decay that benefits your position) relative to the position Theta you would have on the same position at lower levels of implied volatility. With the higher Theta and resulting higher premiums on the sold options in this type of strategy, the probability of success increases because you get a wider profitable range of movement for the underlying. That is why it is important only to put these trades on during extremes of high implied volatility. (To learn more, see Using "The Greeks" To Understand Options.)
Theta is higher with higher implied volatility - given the time to expiration, any additional time premium on an option will result in higher amounts of daily decay, all other things remaining the same. (For related reading, see The Importance Of Time Value In Options Trading.)
Adding More Protection and Profit
Given the first prerequisites are met, we chose a July 35 covered call write and ended up getting $10 for the July 35 ITM call and then went long KCI (see Figure 2 for KCI price chart) at $41.68. This established a breakeven at $31.68 ($41.68 - $10.00 = $31.68). This call option was $6.68 in the money, with $3.32 in time premium, providing a 24% downside protection on this trade. Yet even with this wide zone of potential profitability, it is possible to add more protection and another possible source of profit on this trade. Therefore, we add another leg to this trade - a diagonal (across time) leg. We purchased a December 25 protective put at $2.05, which has a slower rate of time value decay because it is in December. Therefore, if we drop to the breakeven point in the covered write, the December 25 put will be much closer to the money and will increase in value.
For example, should KCI trade 10 to 15% lower going into the expiration week for the July calls, but not so much lower that the covered call strategy gets into any trouble, the December put can pick up any additional premium from the price decline (being short Delta). This might range from $75 to $175 in profit, depending on our mentioned variables. If the July covered call produces its intended gain of $3.32 ($332) in time value, this would now receive a bonus gain of between $75 and $175 if we liquidate the December put at expiration of July calls. (To learn more, see Gamma-Delta Neutral Option Spreads.)
Looked at another way, if we assess the position from an entirely time premium perspective, taken together with the call premium collected, we start with a net time premium of $1.27 ($127 per covered write minus the cost of the protective put), even though we will not lose the entire amount on the long put, and actually may gain from holding this put. In terms of time premium for the July options ex-date, however, we know that we have the potential to collect $332 minus or plus whatever the December put gained or lost at that point.
Depending on if, when and where the underlying stock position was to drop, there are potential for gains on the protective put. This also will serve to provide even more downside protection, pushing our breakeven down to below 30 (approximately) due to the rise in premium on the long puts.
What actually happened, however, was that KCI had a modest move higher and volatility collapsed (a great scenario), allowing us to remove the trade much earlier than the July expiration. On June 20, we were able to close out our July covered call (in the money) plus protective diagonal put. The stock position was closed at $44.12, up $2.44 ($244), following a 20% +/- drop in implied volatility from extremely high levels, as seen in Figure 1.
|Source: Yahoo! Finance|
|Figure 2: KCI price chart|
Therefore, the July 35 in the money call has only increased in value by 50 cents, despite the move higher by the underlying. Meanwhile, our long protective put has lost only 30 cents. Closing at these prices generated an approximate profit of $174 (before commissions).
Since the capital required for this trade would have been just $3,168, the percent gain on this was 5.5% (at $174 profit on $3,373) over a period of just 18 days, which represents an annualized return of 111%. If this position was margined, the returns would be approximately double, but with double the risk.
The Bottom Line
As you can see, this strategy has potential profit in up, down or neutral markets, but downside moves hold the possibility of bonus gains on the long protective put, even though the trade might get into trouble below 30. If this 11 to 12 point drop occurred, an adjustment would be required, resulting in losses on the original position.