Introduction To An In The Money Covered Call
The covered call strategy involves selling call options against stock purchases. The call options could be in the money or out of the money. Therefore, the covered call strategy can be further divided as in the money covered calls and out of the money covered calls.
The in the money covered call is similar to the out of the money covered call strategy. The main differences are :
- The investor writes in the money calls against his stock purchases as opposed to writing out of the money calls for the in the money covered call strategy.
- The potential profit is less than the potential profit of an out of the money covered call strategy.
- The breakeven price point is lower for an in the money covered call strategy as compared to that of an out of the money covered call strategy.
Margin requirement for covered call
Margin is required for covered call positions. The amount of margin required is determined by the broker used. Different brokers have different margin requirements.
Read : Understand The Fundamentals Of Margin requirements
Steps
Step 1 : Perform economic, fundamental and technical analysis
Step 2 : Outlook – Neutral to slightly bullish
Step 3 : Study the option chain
Step 4 : Breakeven Analysis
Step 5: Understand Your Profit Zones
Step 6 : Losses
Step 7 : Calculation of losses
Step 8 : Profit is limited
Step 9 : Calculate Profit
Step 10 : Calculate Risk & Reward Ratio
Step 11 : Set Up Trade : Executing an in the money covered call
Step 12 : Exit Trade : Exiting a covered call position
Step 13 : Record Trade In Diary
Step 1 : Perform economic, fundamental and technical analysis
It is important not to skip this step. This has to be done before a trade is executed. Imagine for a moment that the underlying security is on the verge of bankruptcy a couple of months out but the market has not noticed this yet. In this scenario, the trade will turn into a huge loss. Hence, it is important to perform economic, fundamental and technical analysis. The trader should also look out for chart patterns such as:
Read : Basic Economic Analysis , Basic fundamental Analysis and Introduction to technical analysis
Step 2 :Outlook – Neutral to slightly bullish
The investor who executes this strategy is neutral to slightly bullish on the underlying security. The basic idea of executing this strategy is to generate high returns as in the money call options are worth more than out of the money options and have the stock purchase called away eventually. Eventually, in a neutral market, the investor gets to benefit from the time decay of the option. The investor is also betting that the potential loss on the stock positions is less than the credit received from selling the in the money call options.
Step 3 :Study the option chain
Next study the option chain to select the options to use in the covered call. Since this strategy involves in the money calls, be sure to select call options which are in the money.
Read : Learn to read and understand options chain
Step 4 : Breakeven Analysis
What is the Breakeven price point? The breakeven point is the price point where a trade breaks even mathematically. Hence, if the trade is offsetted at this point, there is no profit or loss except for brokerage fees paid.
The breakeven point can be calculated as:
The breakeven price point = purchase price of the underlying security – premiums collected from writing ITM call option
Step 5: Understand Your Profit Zones
After calculating the breakeven point, a trader will understand where the profit zones are. In this case, the profit zone occurs where the price of the underlying security is above the breakeven point.
Step 6 : Losses
In executing the in the money covered call strategy. there is a greater cushion for losses because the the greater premium collected by writing in the money call options serves to negate the paper loss of the underlying security when the trading price of the underlying security decreases. (In the money call options are worth more than out of the money call options.) In general, a loss occurs when the value of (acquisition price of the underlying security – premium collected) is greater than the trading price of the underlying security.
The maximum loss is potentially unlimited.
Step 7 : Calculation of losses
The calculation of maximum loss is:
Maximum possible loss = Purchase price of the stock – premium collected when writing in the money call options
OR
Loss = Loss on stock position – premium collected + commissions paid
Step 8 : Profit is limited
The profit generated from an in the money covered call strategy is limited to the amount of premium collected. The maximum profit is reached when the exercise price of the shorted call is less than or equal to the trading price of the underlying security.
Step 9 : Calculate Profit
Calculate profit with this formula:
Maximum profit = Premium collected + exercise price of shorted call – purchase price – commissions paid to the broker
Step 10 : Calculate Risk & Reward Ratio
At this point, after learning to calculate profit and loss, calculate the risk and reward ratio based on probable losses and profits. A trader can factor in stop losses into the calculation. The trade should be fairly attractive on a risk reward basis for the trader to execute the ITM covered call. This of course, is in reference to other trades, as well as other ITM covered calls executed in the past.
Read more : Understanding Risk/Reward Ratio For Option Traders
Step 11 : Set Up Trade : Executing an in the money covered call
- Long 100 shares of underlying stock
- Short an in the money call option
The trade is very simple to execute. For every 100 shares long, short an in the money call option simultaneously.
Step 12 : Exit Trade : Exiting a covered call position
- When the price of the underlying security is above the exercise price of the call option, the call is assigned. The writer of the covered call can use the shares from the long stock position to satisfy the obligation of selling the shares to the call option buyer at the strike price of the option.
- If the price of the underlying security iss below the strike price, the written call will expire worthless and the option trader gets to keep the entire call premium. He can choose to write another call against the long stock position to offset the risk on the long stock position.
- If the price of the underlying security falls below the strike price of the call and is also lower than the breakeven point, the trader can hold onto the stock and wait for an upswing in price and still exit at a profit.
A trader should exit the trade when his view of the underlying security has changed. For shorting an ITM call, there is a high possibility that the trader is assigned. The trader will have to go through and assignment and exercise process.. Read : Exercise & Assignment process
Step 13 : Record Trade In Diary
The trade can be recorded in a diary or a journal. Reflect on the trade and find ways to improve on the profitability of the trade.
Example Of An In The Money Covered Call
PQR company is trading at $40 currently. An investor decides to write 1 current month December 35(exercise price of $35) OTM(In the money) call option contract and buy 100 shares of PQR company. He pays $4000 for the 100 shares and collects a premium of $700 for the shorted call option. His effective purchase price is thus:
$4000 – $700 = $3300
If PQR trades at $45 on the expiration date of the option. The loss on the option position would be : $1000 – $700 = $300 The profit on the stock position would be : $4500 – $4000 = $500 The net loss is thus : $500 -$300 = $200
If PQR trades at $35 on the expiration date of the option, the loss on the stock position is : ($40 – $34) x 100 = $500 and the investor gets to keep $700 of collected premium as the option no longer has any intrinsic value. Hence, the profit in this case is : $700 – $500 = $200
Read also :
General Overview Of Covered Calls
Writing Out-Of-The-Money covered calls
Selling options to earn from option premium