In-The-Money Covered Call Explained

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The Basics of Covered Calls

Professional market players write covered calls to increase investment income, but individual investors can also benefit from this conservative but effective option strategy by taking the time to learn how it works and when to use it. In this regard, let’s look at the covered call and examine ways it can lower portfolio risk and improve investment returns.

What Is a Covered Call?

You are entitled to several rights as a stock or futures contract owner, including the right to sell the security at any time for the market price. Covered call writing sells this right to someone else in exchange for cash, meaning the buyer of the option gets the right to own your security on or before the expiration date at a predetermined price called the strike price.

A call option is a contract that gives the buyer the legal right (but not the obligation) to buy 100 shares of the underlying stock or one futures contract at the strike price any time on or before expiration. If the seller of the call option also owns the underlying security, the option is considered “covered” because he or she can deliver the instrument without purchasing it on the open market at possibly unfavorable pricing.

Covered Call

Profiting from Covered Calls

The buyer pays the seller of the call option a premium to obtain the right to buy shares or contracts at a predetermined future price. The premium is a cash fee paid on the day the option is sold and is the seller’s money to keep, regardless of whether the option is exercised or not.

When to Sell a Covered Call

When you sell a covered call, you get paid in exchange for giving up a portion of future upside. For example, let’s assume you buy XYZ stock for $50 per share, believing it will rise to $60 within one year. You’re also willing to sell at $55 within six months, giving up further upside while taking a short-term profit. In this scenario, selling a covered call on the position might be an attractive strategy.

The stock’s option chain indicates that selling a $55 six-month call option will cost the buyer a $4 per share premium. You could sell that option against your shares, which you purchased at $50 and hope to sell at $60 within a year. Writing this covered call creates an obligation to sell the shares at $55 within six months if the underlying price reaches that level. You get to keep the $4 in premium plus the $55 from the share sale, for the grand total of $59, or an 18% return over six months.

On the other hand, you’ll incur a $10 loss on the original position if the stock falls to $40. However, you get to keep the $4 premium from the sale of the call option, lowering the total loss from $10 to $6 per share.

Bullish Scenario: Shares rise to $60 and the option is exercised
January 1 Buy XYZ shares at $50
January 1 Sell XYZ call option for $4 – expires on June 30, exercisable at $55
June 30 Stock closes at $60 – option is exercised because it is above $55 and you receive $55 for your shares.
July 1 PROFIT: $5 capital gain + $4 premium collected from sale of the option = $9 per share or 18%
Bearish Scenario: Shares drop to $40 and the option is not exercised
January 1 Buy XYZ shares at $50
January 1 Sell XYZ call option for $4 – expires on June 30, exercisable at $55
June 30 Stock closes at $40 – option is not exercised and it expires worthless because stock is below strike price. (the option buyer has no incentive to pay $55/share when he or she can purchase the stock at $40)
July 1 LOSS: $10 share loss – $4 premium collected from sale of the option = $6 or -12%.

Advantages of Covered Calls

Selling covered call options can help offset downside risk or add to upside return, taking the cash premium in exchange for future upside beyond the strike price plus premium.during the contract period. In other words, if XYZ stock in the example closes above $59, the seller makes less money than if he or she simply held the stock. However, if the stock ends the six-month period below $59 per share, the seller makes more money or loses less money than if the options sale hadn’t taken place.

Risks of Covered Calls

Call sellers have to hold onto underlying shares or contracts or they’ll be holding naked calls, which have theoretically unlimited loss potential if the underlying security rises. Therefore, sellers need to buy back options positions before expiration if they want to sell shares or contracts, increasing transaction costs while lowering net gains or increasing net losses.

The Bottom Line

Use covered calls to decrease the cost basis or to gain income from shares or futures contracts, adding a profit generator to stock or contract ownership.

In the Money Covered Call Strategy

Selling in the money covered calls can be an excellent income generating strategy for those living off investments .

An in the money covered call strategy involves selling a call option with a strike price higher than the cost of the underlying stock to increase income from stocks.

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After writing covered calls over the past 13 years, I have found that there are times when an in the money covered call strategy works better than an at the money or out of the money covered call strategies.

After investing for almost 40 years, I’ve learned to address the risk involved with any investment first and foremost since you have less time to rebound from losses the older you get, so let’s do that first.

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Risk from Selling in the Money Covered Calls

In the money covered calls tend to be the least risky covered call strategy since they tend to lower your stock cost the most because the option income is the highest, as explained ahead.

The reality is that covered calls are subject to overall stock market risk, with slightly less risk than owning stocks or stock funds without a covered call strategy.

For this reason, you’ll want to always make sure investing in stocks is within your acceptable risk level before even considering selling covered calls, even though the income generated from them is tempting, usually ranging at least two to twenty times that of typical dividend income.

When to U se an In the Money Covered Call Strategy

Below are several factors to consider before using an in the money covered call strategy.

Higher Income from Covered Calls

The closer the strike price is to the market price of the underlying security, the higher the premium is with a covered call strategy. This means that in the money covered call strategies generate higher income than out of the money covered call strategies.

If you’re looking to increase income from covered call writing, it’s worth considering using in the money covered calls. But there is a trade off for this income , and more to consider so keep reading .

More Covered Calls Get Exercised

You’ll want to decide if you prefer that your covered calls get exercised or not. While this isn’t completely under your control, the covered call strategy used will affect the probability that positions will get called at option expiration .

Managing Covered Calls

If you hate managing covered calls, in the money strategies may be best for you since mo re in the money covered call positions get exercised than at the money or out of the money covered call strategies .

This is simply because the strike price is lower with an in the money covered call strategy than it is with an at the money or out of the money covered call strategy.

New Covered Calls Monthly

On the other hand, if you easily find ideas for covered calls and enjoy researching new stocks , you may want all your covered call s to get exercised so you can enter new positions each month to 6 weeks . (I like 4 to 6 week covered call strategies but there are many other time frames, including weekly options .)

Another advantage is that h aving all your covered calls exercised each month provides capital for fresh positions without having to allocate more capital to stocks designated for covered calls . Read my related post on the cash allocation in a portfolio .

My experience has been that usually th e very first covered call on a new position has the best return over managed positions . Likewise, new covered call trades each month tend to generate more income.

We all know there’s no such thing as a free lunch so you may be wondering if it’s more work managing in the money covered calls that didn’t get exercised or starting new covered calls each month.

In my humble opinion, m anaging covered calls is probably a little less work, but that’s offset by the reality that it doesn’t generate as much income as new monthly trades . A t Retire Certain, it’s important to decide how much time you want to spend on your income streams first, and then implement income generating and wealth building strategies from that decision so you can live how you want .

Read my related post How to Create a Wealth Plan that explains this more.

Note that i f you have a good covered call screen er and stock research tools, the time it takes to f ind covered call ideas is greatly reduced.

The other factors for when to use an in the money covered call strategy are shorter but super important so keep reading.

Underlying Stock Is Headed Down

If you think a stock is headed down, selling an in the money option can be the best strategy.

For example, you may have checked a stock chart and seen that the stock is at the high end of the recent trading range . If you’re new to stock charts, while technical analysis can seem daunting, v ery basic technical analysis can be an incredibly valuable tool for choosing the best covered call strategy to use at any given time.

Alternatively, you may have an insight about an upcoming event , such as company earnings or competition, that will likely cause the stock to drop.

In this case, an in the money covered call strategy may work the best as you’ll see below in the example.

The Stock Market Is Declining

The worse thing for covered call writing is experiencing bear markets . That is, until they are over , and t hen they are excellent opportunities for selling covered call s, especially out of the money covered calls .

If the overall market is trending down, however, it usually makes more sense to sell in the money call covered calls than out of the money covered calls and here’s why.

Out of the Money Covered Calls in Bear Markets

First, the further away the strike price gets from the current stock price , the less income generated since the option premium (price) is lower . This is the case with out of the money covered calls.

Second, if you’re selling out of the money calls in down trending markets, those out of the money covered calls are unlikely to get exercised.

When this happens, all your covered call capital gets tied up those covered call stocks that didn’t get exercised .

And s ince the market is declining, it is harder to sell call options near your stock purchase price . This leaves all your capital tied up with little if any income from stocks.

For retirees and ot h ers living off investments who count on covered calls for income, this can be a real challenge. That’s why we have created diversified multiple income streams over the past 15 years in real estate, stocks, and online business.

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In the Money Covered Calls in Bear Markets

Again, selling basic covered calls is hard during bear markets. This is true for out of the money and in the money covered calls. This is why I like to rely mostly on other income streams during overvalued stock markets and bear markets.

Fortunately, however, even when the overall market is declining, stocks move up and down in smaller cycles within the over cycle down. This allows an in the money covered call strategy to capitalize on those mini cycles.

Since an in the money covered call strategy is generally used for stocks likely to decline, and they tend to get called, they can be advantageous during bear markets.

Income Over Capital Gains

Based on your overall wealth plan, you may find that you want income more than capital gains. A n in the money covered call strategy usually generates higher income while reducing or eliminating capital gains.

This is simpl y because when the covered call is exercised, the option seller has to sell the stock at a lower ( strike ) price with an in the money covered call than an out of the money covered call.

In the Money Covered Call Example

Here is an example of an in the money covered call strategy.

Alex bought 600 shares of Retire Corp for $ 18 .50 a share on May 16 . She wanted to generate some income from the stock, so s he sold 6 June call option s with an $18 strike price for $1 .4 0 each .

This gives the call purchaser the right to buy the stock from A lex at $ 18 on the third Friday of June (option expiration) , or June 15 in th at particular year .

It’s important to note that Alex i mmediately g ot $ 8 00 deposited into her brokerage account for the sale of the option s that she keeps regardless of what the stock price does. To see why covered calls can be an excellent income generating strategy for those living off investments, c ompare this to typical stock dividend income.

Covered Call Income Generated from Retire Corp.

The $ 8 00 comes from the following calculation:

$1 .40 per option contract x 6 contracts x 100 = $ 840

When I sell in the money covered calls, I know th at I may have to sell the stock at a loss. If so, t his loss will offset the income generated from selling the call option as explained more ahead.

How Many Stocks Does One Option Contract Represent?

In this example, I multiplied the option equation above by 100 because 1 option contract equals 100 shares of stock.

So, b y owning 600 shares of Retire Corp, Alex was able to sell the 6 option contracts.

Covered Call Taxes and Commissions

Taxes and brokerage commissions are excluded from the calculations in this post. They should be considered based on your own situation.

The good thing for covered call investors is that stock and option commissions have gotten very cheap over the past two decades due to competition, especially with the ability to buy and sell securities online.

Additionally, many investors sell covered calls in IRA’s to eliminate or reduce taxes.

Unless Alex buys back the call option, w hat happens on options expiration depends on the price of the stock on June 15 , the third Friday in June that year .

What Happens at Options Expiration for in the Money Covered Calls?

O ne of 3 things could happen at option expiration as outlined below.

1. Stock Closes at the Strike Price on Options Exp iration

In this scenario, Retire Corp close d at exactly $ 18 , or at the money . This is not common but stick with me because it’s important to understand.

The option buyer may or may not “exercise” the option ( buy the shares of Retire Corp) since the option strike price is the same as the market price on option expiration. Either way, Alex ke pt the $ 8 00 from the option sale.

Assume the option buyer did not exercise the option by buying the stock. At this point Alex has several options. (Pardon the irresistible pun.)

Sell Another Call Option

Alex can sell another call option for the next month. Note that s ince the stock price has dropped from her purchase price of $18.50, the income generated w ill not be as good as the prior month since the stock price (and related option) is lower .

Remember, the pri or month, the stock w as at $18.50 . This was the market price when she sold an in the money call option for $1.40 with an $18 strike. This is one reason so much income was generated from this particular covered call ; it was deep in the money .

The high income trade off with in the money covered calls is that the stock can be called at a loss .

Th is is why doing the option expiration math for all 3 potential outcomes is important before making covered call investments.

Sell a Call Option After Stock Rises

Alternatively, Alex can watch the stock chart and sell a call option near the top of the current trading range to get a higher option premium.

Sell a Call Option with More Time Value

Alex can sell a call option for two or more months out, increasing the option premium by increasing the time value. Decay of time value is a huge advantage for option sellers that naturally happens with covered call writing.

Sell the Stock

Alex can simply sell the stock and close the position.

In this case, Alex would have made $800 from selling the call options. This would be offset by a loss on the stock of $.50 per share assuming she sold it at $18.

2. Covered Call Expires In the Money

In this next possible outcome, assume R etire Corp closes below $18 , or in the money . I t closed at $ 17.16 .

T he option buyer d id n ’t exercise the option since the market price of the stock on expiration day is below the strike price. The option buyer could simply buy the stock for less than the strike pri ce of $18.

It was a little bit of a bummer for Alex , because the stock had dropped in value since it was bought at $ 18.50 . But the good thing is that Alex gets to keep the $ 1.40 for selling the option anyway, which reduces her Retire Corp position cost per share cost to $ 17.10 .

S he would be close to break even on the overall position if she s old her stock at option expiration .

3. Stock Closes Out of the Money on Option Expiration

Assume Retire Corp close d at $ 19 . 0 0 , or out of the money . The option buyer w ould have logically exercise d h is right to BUY the shares at the strike price of $ 18 since the stock price was $1 more than the strike price at option expiration .

In this case, Alex would have to sell Retire Corp. below the market price of $ 19.50 b ut she is okay with that since she did the math for all 3 possible option expiration outcomes before choosing the best covered call strategy given the evaluation .

Alex would have made $ 560 on the overall position as follows:

Loss from Retire Corp Stock

Sales Price of Stock $18.00

Cost of Retire Corp $18.50

Loss on Retire Corp $(.50)

Income from Covered Call Investment

Income from Sale of Option $1.40

Less Loss on Retire Corp – .50

Net Profit per Share $.90

Number of Shares 600

Total Profit $560

As you can see, all the profit from this covered call investment came from the sale of the option premium, as is often the case with in the money covered call strategies.

Keep in mind this is income on one month’s profit from just one covered call position . You can see why covered calls can be a great income generator for stock investors who are already exposed to stock market risk anyway.

Annualized Covered Call Return

Alex’s annualized return on this in the money covered call strategy would be:

Option Net Profit / Cost of Retire Corp $ . 9 0/18.50 = .0 49 x 12= 59 % annualized

This isn’t to say that this same return on investment could be made if this investment were made repeatedly throughout the year. In order to compare a monthly or six week return to an annual return, such as dividend income of 3% a year, it helps to calculate covered call returns annualized.

This turned out to be a v ery profitable covered call trade for Alex with a stock that decreased in value . I usually enter in the money covered call strategies, however, with the expectation that the stock will decrease in value.

Lowering Stock Risk with In the Money Covered Calls

S top losses can be set to significantly lower stock risk when selling covered calls. This work s especially well with in the money covered calls since the overall position cost is lower due to the high option premium.

A lower overall stock cost lowers risk. This lower stock price can also serve as a good place for a stop loss to lower investment risk from stocks. I like to check this on a stock chart while also factoring in the risk I am willing to accept.

At times of high volatility, for example, I have gotten to a 1% loss potential while selling covered calls. Let me know in the comments if you’d like to know more about covered call risk management and I can write a post about it.

Summary for In the Money Covered Call Strategy

As you may have guessed, not all in the money covered call investments are profitable, but many are. Before deciding whether to use an out of the money, at the money or an in the money covered call strategy, consider the above factors, such as overall stock market direction and your own goals.

This top down analysis will guide you to the best covered strategy to reach your goal s .

Get my free eBook with our top 9 strategies to build wealth while generating income.

Disclaimer: Nothing in this post is meant to be taken as personal financial advice. You are responsible for your money

What is a Covered Call? Learn the Pros and Cons

Before diving into the complexities of what a covered call trade is and how it can be used to generate portfolio income lets first define what an option contract is and what it means to each party involved. There are two main types of options, call options and put options. A call option is a contract that gives the holder (buyer) the right, but not the obligation, to buy a security at a specified price for a certain period of time.

Buying one call stock option gives the purchaser the right to buy 100 shares of a stock. If the stock price is greater than the options exercise (strike) price the option can be exercised and the option buyer will make a profit based on the difference between the current price and the strike price. When this happens the option is considered to be ‘in the money’. If the price of the stock is below the strike price on expiration the option becomes worthless or ‘out of the money’.

It is possible for an investor to either buy or sell options; selling naked calls means an investor sold a call option without owning any underlying stock to offset option. Selling naked calls is a very risky endeavor. If an investor sells a naked call and the stock dramatically rises above the options strike price the investor will owe 100 times the difference between the stock price and the options strike price.

Both buying call options and selling naked call options are speculative strategies where the investor stands to only make a profit if they correctly guessed the direction of the stock’s price.

Between the date the option contract is initiated and the date it expires the price of the stock will constantly fluctuate. The more a stocks price is expected to fluctuate over this time frame the harder it is to predict whether or not the option will be in the money at expiration. To account for this, options are priced at a premium, and that premium declines as the expiration date nears. All else held the same, an option expiring in one month will be worth more today than tomorrow if the stock price remains the same. For more detailed information on how options are priced read The Greeks: From Past to Present.

Covered Calls Explained

What is a covered call? Let’s now look at an example. XYZ stock is trading at $52 today; a call option to purchase XYZ at $55 one month from now is priced at $3. To initiate a covered call on XYZ stock an investor would purchase 100 shares of XYZ and sell a call option which obligates him to sell XYZ at $55 one month from now if exercised by the option buyer. For simplicity we will ignore commissions.

Pros of Selling Covered Calls for Income

– The seller receives the premium from writing the covered call immediately on the date of the transaction, in this case $300. If the price remains below $55 at option expiration the seller will keep the 100 shares of stock and the $300 he received for the option.

– If the price of the stock is over $55 at option expiration the call option will be exercised. At this point the 100 shares of stock are sold, the investors profit is equal to the $300 received for selling the option plus the $300 in capital appreciation (100 shares * ($55 sell price – $52 purchase price)) for a total profit of $600.

– The premium received can help offset a downward move in the stock price. In this example the investor purchased the shares at $52, if the stock were trading at $49 on expiration and the investor decided to sell his shares the total profit would be $0. The $3 loss on the shares of stock is offset by the $3 received in option premium.

Cons of Selling Covered Calls for Income

– If the stock rises well above the strike price, the seller does not enjoy the full appreciation. The seller’s profit is limited to the premium received plus the difference between the stocks purchase price and the options strike price.

The option seller cannot sell the underlying stock without first buying back the call option. A significant drop in the price of the stock (greater than the premium) will result in a loss on the entire transaction.

– Premium amounts are based on the historical volatility of the underlying stock. Stocks with higher option premiums will have a greater risk of price fluctuation.

– Losses due to downward moves in the underlying stocks price are only limited by the amount of premium received.

Is Selling Covered Calls “Worth It”?

As you can see, selling covered calls for income offers both advantages and disadvantages to outright stock ownership. They can be a great tool to generate additional income from an equity portfolio; however using only a simple covered call strategy can get you into trouble due to its limited upside potential and limited downside protection.

Strategies using options to generate income can be as simple as selling covered calls, while others add strict rules and processes to manage income, emotion and risk. If you are looking to add an income producing strategy using options, compare the risk/reward profiles of every strategy and pick one that matches your objectives, risk tolerance, time horizon and temperament. For more information on using options in your portfolio read our free special report: Myths & Misconceptions About Exchange Traded Options.

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