blog

Selling Deep In The Money Covered Calls: Why Do It?

Options Trading 101 - The Ultimate Beginners Guide To Options

Download The 12,000 Word Guide

Get It Now
As Seen On
by Gavin in Blog
March 25, 2021 0 comments
deep in the money covered call

What exactly is a deep in-the-money covered call? Today we will answer that question ask and why traders sell deep in the money covered calls.

Contents

Introduction

Well, there is no definitive answer as to what a deep in the money call is.

If you look at this webpage, you will get the definition of a deep in-the-money option according to the Internal Revenue Service (IRS).

Essentially, the IRS definition says that a deep in the money option has two components.

The first is how many strikes an option deviates from the price of the underlying financial instrument.

For example, an in-the-money call option will have several strikes below the price of the underlying instrument.

A put option that is in the money will have a certain number of strikes that are above the price of the underlying instrument.

The second factor the IRS looks at in determining whether an option is deep in-the-money is how far out in time the expiration date of the option is from the date of purchase.

The IRS defines this as an option that is:

– More than one strike away from the price of the underlying if the expiration date is less than ninety days

– Or more than two strikes away if the expiration date is more than ninety days.

Essentially, if the option has less that ninety days until expiration, only the first strike is not deep in the money.

Access 9 FREE Options Books

If the option has more than ninety days, only the first two strikes in-the-money are not considered deep-in-the-money.

While the IRS definition of a deep in-the-money option might be the one used in a court of law, most option buyers and sellers tend to look at an options delta as the determinant of what constitutes deep in-the-money.

Most traders would tend to agree that an option goes deeper in-the-money as the call delta approaches 1.00 and the put delta approaches -1.00.

Traders should also consider portfolio margin when selling options.

Portfolio margin issues are discussed here.

The simple fact is that traders won’t sell deep in-the-money options without a corresponding long position because of the effect on buying power.

Why Sell Deep In The Money Covered Calls?

The reasons why you might sell a deep-in-the-money option can vary from individual to individual, but they generally tend to fall into three primary categories.

First, buyers who like to use covered calls can sell deep in-the-money options if they are looking to get out of the stock.

By selling a deep in-the-money call, it is highly likely the stock will get called away.

Traders employing this strategy are not overly bullish on their stock position.

Second, if someone who is long an optionable stock wants to maximize their down-side safety they can sell deeper in-the-money options to allow for more down-side safety.

Third, there are times when you can reduce the cost of a stock by using deep in the money options to help buy it at a reduced cost. The rest of this article will discuss these strategies.

Rolling An In The Money Poor Man’s Covered Call

A poor man’s covered call is a diagonal spread that involves buying an in-the-money call and selling an at-the-money or out-of-the-money call.

Often, when a stock goes up in value, the short option goes deeper in-the-money, and you find yourself selling deeper and deeper in-the-money calls to continue rolling the short option forward.

Now let’s look at another scenario.

In The Money Covered Call Example

Let’s work through an example of an in-the-money covered call.

Trade Date: November 12, 2020

Underlying Price: SPY at 353.68

Trade Details:

Buy 100 SPY shares @ $353.68
Sell 1 Jan 15, 2021, SPY 352 Call @ $12.86

Capital At Risk: $34,082

Max Gain: $1,118

Time Premium Sold: $11.18 (12.86 – (353.68 – 352))

rolling deep in the money covered calls

Fortunately, this was the lowest close for SPY over the next 64 days, so the option never goes out-of-the-money.

On the expiration date of January 15, 2021, SPY closes at $375.70 and the shares get called away for a total return of $1,118 or 3.28%

Without the option sale, the return would have been slightly higher at $2,490 or 7.04%

Going Deeper In The Money

Now let’s see what happens if we sold an even deeper ITM call.

Trade Date: November 12, 2020

Underlying Price: SPY at 353.68

Trade Details:

Buy 100 SPY shares @ $353.68
Sell 1 Jan 15, 2021, SPY 332 Call @ $27.70

Capital At Risk: $32,598

Max Gain: $602

Time Premium Sold: $6.02 (27.70 – (353.68 – 332))

selling deep in the money calls on dividend stocks

Note here that the return potential is lower, but the breakeven price is also much lower.

In the first example, the breakeven price was around 340.82 and, in this example, the breakeven price is 325.98.

At expiry, the trade received the full profit of $602 or 1.85%.

You can see that selling a deeper in-the-money call is a much more conservative trade with a lower return potential and more margin for error on the downside.

AMAT Example

Let’s look at another real-life scenario. On December 11, 2020, you notice that AMAT has gone up almost 60% in the last twenty-eight market days.

You get a bad case of fear-of-missing-out (FOMO).

You decide to buy 100 shares at $89.89 at the close of the day.

You also sell an 85-strike call with 36 days to expiration for $5.68.

Trade Date: December 11, 2020

Underlying Price: AMAT at 87.89

Trade Details:

Buy 100 AMAT shares @ $87.89
Sell 1 Jan 15, 2021, AMAT 85 Call @ $5.68

Capital At Risk: $8,221

Max Gain: $279

Time Premium Sold: $2.79 (5.68 – (87.89 – 85))

deep in the money covered calls

The next day, AMAT starts to tank.

By December 29, 2020, the price of the stock has dropped to $84.27.

Without the short option the trade would now be down $3.62 or 4.12% on the stock.

However, the short option has fallen to $2.13, meaning that the covered call position is down only $0.09 or 0.11% on a cost basis of $82.21.

At this point, we roll the option out one week and drop the strike to 80 for more safety.

Trade Details:

Buy 1 Jan 15, 2021, AMAT 85 Call @ $2.13
Sell 1 Jan 22, 2021, AMAT 80 Call @ $5.87

Net Credit: $3.74

The cost basis gets reduced to $78.47, and we have the obligation to sell the stock at 80 if called upon to do so.

This gives a profit potential of $1.53 or $153 in total.

deep in the money covered calls dividends

AMAT recovers its upward climb and by the expiration date of January 22, 2021, has reached a price of $106.33.

At this point the shares are called away for $80 leaving a total profit of $153 or 1.95%

If the investor had just bought and held the 100 shares of AMAT stock, then the total return would have been $1,844 or 20.98% so we can see in this example the deep in-the-money call strategy has significantly underperformed.

However, the purpose of selling deep in-the-money calls is to generate income and reduce downside risk.

So, by those criteria, the trade has achieved its goal.

Selling In The Money Calls To Reduce Cost Basis

Another reason to sell deep on the money options is to reduce your cost on stocks that you want to own.

Many investors want to try and accumulate stocks that pay great dividends.

Great dividend paying stocks are stocks that pay a better than average dividend and have done so consistently for a relatively long time.

Ideally the company has also consistently increased that dividend during that time.

Can selling deep in the money calls help investors get bargain basement prices on good stocks?

Conclusion

Selling deep in the money options can be a great income strategy that gives more downside protection than a regular covered call.

However, this strategy will underperform in strong bull markets.

There is a time and a place for selling deep in-the-money covered calls and that is when the investor has a neutral outlook and wants to generate some additional income.

Trade safe!
Gav.

Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.

vol trading made easy

Leave a Reply

Your email address will not be published.

Options Trading 101 - The Ultimate Beginners Guide To Options

Download The 12,000 Word Guide

Get It Now