The market sucks today, with a bad risk to reward ratio. I have time to respond, but there are people here much better qualified to advise you than I.. My comment related specifically to the original post in which it was proposed to buy stock and sell a deep in the money, far out call against it. This is a terrible strategy, because the goal of selling a covered call is to sell as little intrinsic and as much extrinsic value as possible, with maximum decay rate of the extrinsic. The front month atm call satisfies these requirements best. Extrinsic is at a maximum and the intrinsic at a minimum for the atm call. You want to sell the front month because theta won't change much until you are about three weeks from expiration. Your goal is to sell extrinsic value and see it decay away as rapidly as possible due to theta becoming exponentially more positive as expiration is approached. You would never want to sell a call deep in the money and far out against long stock, because you would not see much increase in theta on the short call for several months, while in the meantime you have money at risk tied up in the stock, and stocks go down as well as up. But the most important reason why you would never do this, I hope, is that the deep in the money short call will have a delta of .8 to .9 and therefore maximizes the intrinsic and minimizes the extrinsic, which is just the opposite of what you want. The other aspect to this is that you should limit this strategy to stocks that are in a slow upward grind. You want the stock to go up in value, not down. But go up slowly. In general, this is not a good strategy in a down market. If you do decide to sell a covered call, then please follow the stock price carefully. You would likely want to liquidate the position should the stock break below its trendline. You should consider diagonals. Selling a diagonal is often a better strategy than selling a covered call. In a diagonal you sell the front month, atm call and buy a deep in the money (delta .8 to .9) call several months out for a stock that is in a slow upward grind. The ditm long call is a substitute for long stock , but ties up less capital than if you had bought the stock itself. If all goes well, the front month option you sold will expire worthless, atm, or barely in the money. (You have the ditm long call for protection should the stock really take off, but you still have to be on guard against the underlying tanking.) You can buy the sold call back, if you need to, once nearly all of its extrinsic value has decayed away. Then you keep the far out (several months, say three) ditm call, and sell the next, front month, atm call. Do this repeatedly, and you will do much better than if you had sold a back month atm option just once, and waited several months for its time value, i.e., its extrinsic value, to decay. May i strongly recommend that you do a lot of reading about options before jumping into them. And then start slowly, one contract only, until you begin to show consistent profits. It important to have a good working knowledge of the Greeks before taking the plunge into options. Trading options without much understanding is a good way to lose a lot of money. Sadly, there is no such thing as a riskless option strategy. I have always liked the little book on options published by the Financial Times as being especially well-written, but there are many good books to choose from. I would not recommend trying to read the more advanced books, such as Cottle's, until you have the basics down.
At the risk of being called an idiot(been called worse) I have a question. Stock xyz is trading at 6.90 today and I buy 100 shares to execute a covered call. My cost is 690 bucks + commish. I sell a Oct. 5 Call for 3.20 and collect the 320 bucks less commish. I fully expect to have the shares called away at some point between now and Oct. and they'll go for 5 bucks a share = 500.00 690 - 500 = 190 loss offset by the 320 collected, so I have a profit of 130 dollars less commish, right? That's 18% on my money over a two month period if it goes the full two months. What's my risk? If my plan going in is to make the 130 and I don't care how high it goes cause that ain't the plan for this trade, what's the problem? It can go to 50 for all I care. I executed my plan to make 130 bucks/18% profit and I got it. Pick it apart, cause it looks good to me. Thanks in advance for any critique.
Your risk is that the stock drops to zero (worst case). If the stock drops to zero then you lost 690 on the shares and collected 320 on the call, so your net loss is 370.
There's nothing wrong with your numbers. Your downside BE is 3.70+costs. The only problem, assuming a standard contract, is that the IV for that option is about 240. If a Co. has Oct. contracts with that kind of IV, then something is expected that will cause a good deal of volatility. For example, you might see a one trick biotech with this kind of pricing. If things go well 15+/share might be expected, you'd miss most of that at +1.30. If the results are not good the stock may go sub 1. In this hypothetical example your R/R isn't that great if the event is probable before Oct. expiry.
^ I appreciate both of your comments and the risk is what I expected, but did not ask. The stock could go to zero. Unlikely, but anything can and does happen. Yes, it is a bio-tech, IV is through the roof, event is expected prior to experation and the low of the stock has been 2.90 over the last year. There are probably better ways to play this, but my primary question at this point was just about how an ITM Covered Call would work. Thanks again for your comments.
On a side note, if you are planning on buying the stock just so you can do a covered call then consider selling a put instead (e.g rather than buying the stock and selling a 5 call just sell a 5 put). It's exactly the same payoff with half the costs.
I see that. Thanks! Actually I already own the stock and I'm now becoming interested in selling calls on the stock(s) I own. In this case, it seems that writing a slightly OTM Call is better than an ITM so that I can capture some of the potential upside. There is the possibility of a crash and burn, so I was thinking of using a portion of the proceeds from the write to buy a couple OTM Puts for downside protection. Typically I would think a person would just write the call and with a slightly bullish bias and have no need to buy a put. In this particular case, with the potential for an extreme move down, I'm just looking for some cover. I'm just trying to learn some more about options other than buying calls and/or puts, which has always been pretty much a bust for me.
Well hell, you get a cookie for that, and guessed what I did, almost. I sold the Oct. 8's and have yet to buy any Put's. My thinking, however convoluted, is that the price on the Put's today are juiced by expiration and the recent dip down. I expect a run up during the FDA news next month, just not as much as the pumpers are hoping for. I don't think it will ever get to 9.
Edit... this is poorly phrased. A collar equals a vertical. If one had no equity position, one would be better served by doing the vertical since there's less slippage and commissions... unless one's intent was to intraday trade a component (usually the underlying) against the position.