Deep-ITM covered calls

Discussion in 'Options' started by ADLE, Mar 11, 2006.

  1. ADLE


    Hello ALL,
    I am newbie to options and I'd like to discuss writing Deep-ITM covered calls.
    What are advantages and disadvantages of this trading strategy.
    Let's say, I bought XYZ at 10$ 100 shares and sold against my position deep ITM leap calls of January 2007 at 7.5 strike price and received 3.50 premium, now I paid for my position only 6.5*100 = 650, instead of 1000.
    So if stock goes up or stays neutral my position in 100$ profit 750-650 = 100.
    What disadvantage: I had allocated part of my account and don't know when I will be assigned to sell my 100 shares at 7.5
    I start losing when stock's price goes below 6.5 price - I can calculate and close my position before as breakeven.
    My advantage is low risk strategy with almost immediate profit when position got assigned.
    I have questions:
    First of all as newbie I don't know how it really works:
    If I wrote calls at 3.5 for strike 7.5 (actual price of stock was 10 when I wrote these calls), when I will be assigned, do I sell my 100 shares at 7.5 or at 6.5?
    Whom do I sell my shares to guy who bought from at 7.5 and should wait until price will be above 7.5+3.5=11 or it can be any trader/investor who has options for 7.5(I know it maybe dumb question , but I want to be clear on this one, do exchange keep track who buy/sell and what time/strike price)?
    If you can recommend any book that covers Deep-ITM covered calls, it would be great, I have no luck to find this one, people explain a lot about writing covered call slightly out of money, but not deep-itm :-(

    Thank you for any input.
  2. OTR


    Covered calls are a great way to increase your return, and lower your risk. There are a couple things you might want to consider about your approach.

    First, the biggest advantage to an option writer is time. Time works in the writers favor. The time value built into an options price decreases most rapidly immediately prior to expiration. Therefore, Covered Call writers will receive the most benefit by writing covered calls in the near month, or one month out.

    Secondly, there are advantages to writing your covered calls on out-of-the-money options versus in-the-money. You can find these advantages outlined in many books on options, including "New Insights on Covered Call Writing,". I reviewed this books and a few others on my site at:

    Another great way to lower your cost-basis and get into stocks at the right price is by selling puts to initiate your position.

    Take a look around my site. You'll find a tutorial on covered call writing and some great links for additional info. Feel free to email me if you have any questions.


    Option trading information and tools the pros wish they had! A former Chicago Mercantile Exchange employee reviews stock option trading software, books, and web sites and online income opportunity.
  3. what is your cost of carry

  4. Really?? I wasn't aware of any of these types of strategies. Are they new?
  5. pvram68



    To answer your question, now that you wrote (sold) the call for 7.5 strike, you do not have anything else to do. To look at it another way, you have no unconditional ownership on your stock anymore as you already gave the rights up until the option expiry to the option buyer.

    When the expiration date comes close, you will know if the option is in the money and whether it will therefore be assigned or not. You have two choices at that time:

    1) Buy back the call that you sold earlier at the last moment -- if the stock came down in value and hence the option got substantially cheaper (but still in the money) you can buy it back and realize the profit on the earlier sale of the option, this is similar to a short sale. Effectively you would have collected the time value of the option into your pocket, other things remaining same.

    In your example, if you sold the 7.5 March call for $3.50 and stock price remained at $10 at 3:59 PM on the expiry date. The option would have lost all its time value by then and it should be trading close to $2.50 which is the intrinsic value of the $7.5 call option with stock at $10. So buying it back would fetch you the $1 premium ($100 per contract, minus commissions)

    If you like what you did for this month in earning a $100 return on a $1000 investment and would like to repeat it with the same stock for next or subsequent month again, you'd like to retain the stock itself and therefore buying back option would be a good option. As soon as you buy it back, you can sell the same kind of covered call for the next or any future month readily again.

    2) If you don't act on an in the money covered call option that you wrote, at expiry time it will be assigned to you. If it is $0.25 in the money (if the stock price is more than $7.75 in your example) the broker is required to automatically exercise the right of the buyer and therefore take away your shares which were covering the call option. When this happens, your stock itself would be shown as sold at $7.50 regardless of the current market price.

    If you want to repeat this exercise for a subsequent month, you have re-purchase the stock and re-sell the option in this case. But it gives you the freedom to choose any other stock or the same stock for the next play.

    Between both choices, there are two implications that need to be taken care of:

    a) Broker commissions:

    different brokers charge different commissions for options trades and for assigning your shares to your written call. These commissions are not insignificant for small players and can actually lead you to a decision on which among the two is a better option (I mean, choice) for a covered call.

    b) Tax implications:

    Options trades are much more complex to deal with for filing taxes than stocks. I realized it the hard way when I was doing my taxes recently after my first full-action year 2005. Covered call writing has a special mention and a tax haven in the tax books, but this advantage is lost if the option is deep in the money and is sold less than 30 days before expiration. In fact, if it is a longer term option, you can use a little more in the money strike for writing the call rather than when the expiration is shorter. I am not supposed to and not going to give speicific tax advise, but I encourage you to carefully read the IRS publication 550 about the covered call and its tax implications. If the tax haven is not taken care of, you'll then have to bother about a plethora of other stuff like wash sale rule etc. and the tax scenario is going to get uglier later. Once you study this rule carefully, I am sure you will be able to come up with a plan to manage the covered call writing beter. At the outset it may be better to sell options every quarter rather than every month to get a more favorable treatment in tax terms, and it might also lessen your commissions substantially.

    Finally, talking about the risks, one of the major risks of covered call writing is if the underlying stock falls substantially and suddenly. In this case before you can sell your stock you have to get rid of your obligations that is, you might have to buy back the call option that you wrote. Unfortunately, because of various factors that influence the option pricing, option might itself not come down in price so much as the stock does. Therefore you will possibly be looking at a loss if you want to liquidate your positions before expiry. Writing a more in the money call will be probably good in this case as the chances of your stock being above the strike price is better, and therefore your chances of automatically getting rid of your stock at the pre-sold strike price. Who wants to keep a falling stock anyway.. But if it falls even below the strike that you sold at, and the expiration is far off, you have a tough choice between waiting for the expiration (and keep all your writing premium) or buy back the call and sell the stock immediately.

    Hope this helps,
  6. Maybe you do not realize that a naked Put is the synthetic equivalent of a Covered Call. Therefore you can accomplish the same thing by simply selling a NP. Using a NP is generally better because it's simpler (fewer commissions, etc).

    One major caveat, if your broker does not pay a decent interest on your cash the CC may be better. Include the interest implications when comparing the P/L of the CC vs NP and that will tell you which is better.

    Generally, if you use IB they pay decent interest so the NP is better. OX and TOS margin accounts pay lower than IB, but the NP might still be better. OX and TOS IRA's pay ridiculously low rates on cash for the cash-secured Put so a CC will likely be better.

    As always do the math before deciding and don't forget to include dividends in your calculations.

  7. zdreg



    Registered: Jan 2006
    Posts: 21

    03-12-06 01:05 AM

    Covered calls are a great way to increase your return, and lower your risk.

    what proof do you have that covered call writing increases your return and lowers your risk? there use to be close end funds writing covered calls and their returns were mediocre, perhaps covered call writing is nothing but a commission genrator for wall stree t and a fee generator for some hedge funds,
  8. OTR


    zdreg poises some interesting questions. the CBOE has created a Buy-Write Index (BXM) to address some of these issues. You can learn about it and see how it performs at:

    In a nutshell, a buy-writie strategy seems to outperform the S&P 500 in down years and years when the market has up to a 20% increase. Buying stocks alone outperformed the buy-write index in 1995-1998 when the S&P 500 had returns greater than 20%.


    Option trading information and tools the pros wish they had! A former Chicago Mercantile Exchange employee reviews stock option trading software, books, and web sites and online income opportunity.
  9. ADLE


    Thank you guys for input, very informative.
    When I write calls deep in the money I want my position to be assigned as soon as possible, from your input I understand that if I write leap calls I can wait for year to be assigned. :-(
    How about buy stock and write current month ITM calls, how quick I would be assigned?
    Lets say I bought at 30$ 100 shares and sold 2.5$ calls for current months 30 calls, calls were expensive because of high IV. How does it work?Is it really a lottery or there is some system?
    And why people after third week Friday are waiting till Tuesday to see if their written calls were expired or not?It's not enough to see what happened by the end of Friday's trading session?
    Sorry again for dump questions, but I couldn't find answers on these in any book, people usually write "you have to buy back your covered calls for less on third Friday" without really explanation Why I should buy back for less on third Friday if I see it's almost worthless? I hope you understand, sometimes even in books that covered basics you still have question - why.
    Thank you.
  10. OTR


    Options are seldom assigned prior to expiration. Most people will simply sell a call that they are long rather than take the trouble and pay the extra commissions to exercise the option and sell the stock. One of the previous posts explained the assignment process. You typically will get assigned immediately after the expiration (3rd friday of the month). The people that are buying back the call prior to expiration are doing it to avoid being exercised. They want to hold onto their stock.

    Think things through and do some reading. I've got a feeling I know where you are going with this, but CC's are not a sure thing. The biggest mistake I made when first doing covered calls was selecting poor quality stocks. One CC stock dropped 33% the day after I bought it. I still own the stock and sell calls every month against it, bringing down my cost basis to a point that I have recovered the paper loss. Still, I'd rather not have this stock in my portfolio, but am forced to hold onto it for now.

    Good Luck.


    Option trading information and tools the pros wish they had! A former Chicago Mercantile Exchange employee reviews stock option trading software, books, and web sites and online income opportunity.
    #10     Mar 12, 2006