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Writing In-the-Money Option Calls

Filed Under Beginner Options Trading 

Writing In-the-Money Option Calls
New investors often wonder how it is possible to profit by purchasing a stock for one price and giving someone else the right to buy it for less money. The answer is there is a time premium associated for that right that more than makes up for this loss. We know this from Pricing Principle #4 in Chapter Two which showed us that all call options must be worth their intrinsic value plus some time premium. If you sell an in-the-money call, you receive more money than the intrinsic value you’re sacrificing.
 
For example, using Table 7-1, you could buy AGIX for $18.81 and sell the $15 call for $6.20. Notice that you are taking a loss on $18.81 - $15 = $3.31 worth of intrinsic value but are paid $6.20, which more than covers the loss.
 
Pricing Principle #1 showed us that lower strike calls are more expensive. Therefore, writing in-the-money calls against your shares provides a bigger cushion if the stock price should fall. Even though in-the-money calls are more expensive overall, they carry a smaller time premium and it’s the time premium that reduces the cost basis of the stock. This is why writing in-the-money calls increases the downside hedge (they are more expensive) but provides lower returns (there is not as much time premium as an at-the-money call). In other words, investors who write in-the-money calls are taking less risk and will therefore get lower returns.
 
Buying the stock for $18.81 and selling the call for $6.20 gives you a cost basis of $18.81 - $6.20 = $12.61 and gives you the potential obligation to sell your shares for $15 call, which represents a 12.6% return.
 
Figure 7-4 compares the profit and loss diagrams for selling the $20 call (bold line) verses the $15 call (shaded line). You can see that the $20 call provides for a higher return but the $15 call provides better downside protection. Selling the $20 call carries more risk and more reward than sale of the $15 call:
Figure 7-4
 

Figure 7-4

If there were lower strikes available for AGIX, we would find that the returns would eventually converge on the risk-free rate. Notice this is consistent with our observations about time premium in Chapter One where we said that lower strike calls will have very relatively small amounts of time premium in them and it’s the time premium that creates the returns for the covered call strategy. Now that you understand the covered call strategy, you have another way of understanding why time premiums shrink as you move deeper in-the-money. If you write calls that are so far in-the-money then the shares will be nearly guaranteed to be called away and, as with any guaranteed investment, you will only receive the risk-free rate of return.
 
For example, assume a stock is trading for $100 and that a one-year $20 strike exists. Interest rates are 5%. How much should the $20 call be trading for? In this case, if you buy the stock for $100 and write the $20 call, the market would probably view this as being a nearly guaranteed sale for $20 in one year. If you are “guaranteed” to receive $20 in one year, then it is worth $20/1.05 = $19.05 today, which means there is a cost of carry of $20 - $19.05 = 95 cents. We know the call must also be trading for the intrinsic value so it should be worth $80.95. You can verify this by using a Black-Scholes Model with a volatility of 50% or lower so that our assumption of “nearly guaranteed” is valid. You’ll find the $20 call is worth $80.95. As a call writer, you’d only receive the cost-of-carry for this trade since you’re not taking that much risk in the eyes of the market. If you increase the volatility to something higher than 50%, you’ll find the time premium starts to increase showing these higher volatility levels are casting some doubt as to whether that option seller is guaranteed to receive $20 in one year.
 
 
Which Expiration Should I Write?
As with strike prices, there will be several expiration months from which to choose. All things being equal, you’re better off writing the shorter-term contracts for a couple of reasons. First, shorter-term contracts are exposed to a much more rapid pace of time decay. This means their value diminishes quickly, which is what you want to happen as the writer. A second reason is that short-term options are more expensive per unit of time, which we learned from Pricing Principle #5 in Chapter Two. 
 
But this does not mean there’s no benefit in writing longer-term options. Longer-term options do provide more money and therefore provide a larger hedge if the stock should move against you. As we have shown, the risk of a covered call is that the stock falls and, by bringing in higher premiums, longer-term options help to hedge against this risk. Also, what if it takes a while for a fallen stock’s price to recover? During the recovery time, you may not be able to write the strike prices you had hoped and may end up not able to write any calls until the stock recovers (if at all). By writing longer-term options, this risk is mitigated.
 
Every option strategy in the world is a unique tradeoff between risk and reward, so it’s not correct to say you should only write short-term options. We’re just saying all things being equal you’re better off writing shorter-term calls. And having the stock price remain the same month after month is one of the assumptions in the phrase “all things being equal.” If the stock price is very volatile, you may consider writing a longer-term option against it to further hedge the downside risk. When people tell you to only write the short-term options, they are implicitly assuming the stock price will remain fairly constant and they will be able to write calls month after month. If that turns out to be false, then writing a longer-term option may end up being the better strategy. So when deciding which month or strike to write, just be sure to take all risks and rewards into account and make sure they are in line with your outlook on the stock.
 
Regardless of which month or strike you choose to write, most covered call writers wait for the time value to get near zero, which will be close to expiration, and then write another call at that time. The idea is to continually collect premiums over time. The covered call strategy is usually not used as a “one-time” strategy although it certainly could be used in that way or for shorter-term applications. But for the most part, the strategy is designed to be a long-term, systematic way to continually collect premiums and reduce the cost basis of your shares and enhance returns.
 
 
Covered Call Rationale
Now that you understand the profit and loss profile of the covered call, we can answer one of the most frequently asked questions about the strategy. Many investors wonder why anybody would write a covered call since it limits your upside potential. They reason that it doesn’t make much sense to take in a couple of bucks up front in exchange for limited upside gains and therefore, it must be a bad strategy.
 
But let’s take a little different view by considering the fact that for any stock price, there is a range of possible stock prices that fall into a bell curve pattern. So while “unlimited” upside gains are a possibility, they do not come with equal probability. Each successive higher stock price is less likely than the previous price. Figure 7-5 compares a long stock position in AGIX (shaded straight line) to the long stock + short $20 call position (bold line). We have also overlaid a bell curve at the current stock price of $18.81 to simulate the possible range of stock prices at expiration:
 
Figure 7-5

Figure 7-5

 
Now we see a different picture. If the range of probable (not possible) prices falls under the bell curve, notice that the covered call beats the long stock position for the majority of the ranges under the curve. In other words, the bold line lies above the shaded line for nearly all stock prices under the curve. This means that over time, the covered call will provide more stable returns and will provide higher returns most of the time. However, this does not mean that the covered call strategy produces higher returns for less risk. The covered call writer attempts to keep a steady increase in the returns while allowing the compounding of those returns to work to his advantage.
 

While it may be the winning strategy for some stocks (or for some periods of time) it cannot always be the higher return strategy for the market overall. The reason is that you will miss out on occasional homeruns by continuously staying in the covered call. Notice though, that these “homeruns” occur well outside of the bell curve, which means these homeruns are more like lottery tickets and that you shouldn’t invest with the expectation of those returns. Covered call writers are looking for steady gains month after month. And when it comes to investing, slow and steady can produce remarkable returns especially when you consider the compounding effects over time. It is often the strategy that wins the race and is one of the strongest motivations for using covered calls.

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