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 using an in-depth example.

Key Takeaways

  • A covered call is a popular options strategy used to generate income in the form of options premiums.
  • To execute a covered call, an investor holding a long position in an asset then writes (sells) call options on that same asset.
  • It is often employed by those who intend to hold the underlying stock for a long time but do not expect an appreciable price increase in the near term.
  • This strategy is ideal for an investor who believes the underlying price will not move much over the near term.

Traditional Covered-Call Write

Let's look at a historical example using Rambus (RMBS) shares, a company that manufactures and licenses chip interface technologies. We can begin by looking at the prices of May call options for RMBS (see Figure 1 below). While this may be an older example, the principles and mechanics still apply today and remains instructive.

RMBS closed on the date of our example 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 (ATM) or out-of-the-money (OTM) 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 most active stocks to write calls against, based on a screen for covered calls done after the close of trading. Looking at Figure 1 below, it would have been possible to sell the upside May 55 call at $2.45 ($245) against 100 shares of stock. This traditional covered call write would have upside profit potential up to the strike price, plus the premium collected by selling the option (i.e., up to $57.45).

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 a cushion, after which the stock position can experience un-hedged losses from further declines. Clearly, the risk/reward seems misplaced.

An Alternative Covered Call Construction

Looking again at Figure 1, one could instead look to an in-the-money option to sell, if there is enough time premium (intrinsic value) on the deep-in-the-money option. Looking at the May 25 strike, which is in-the-money by $13.60, there remains some decent time premium available, $1.20 ($120). In other words, if one sold the May 25, they could collect $120 in time premium (the maximum potential profit).

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

Looking at another strike, the May 30 in-the-money call would yield an even 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 the 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 shown 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

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 thus a wider potential profit zone, than the traditional at- or out-of-the-money covered writes.