Covered Call Writing - A Cheaper Safer Way To Do It

Covered Call Writing is regarded as one of the most dependable option trading strategies. The manner in which it is usually presented is, that you buy the underlying shares and after that sell call options on them. You can sell them out-of-the-money, at-the-money and even in-the-money, each with various outcomes, depending on current market conditions and anticipations.

Purchasing the underlying shares needs a sizeable sum of capital. If the latest stock price is say, $40 then it would cost you $4,000 to buy 100 shares in the united states and that means you could write just one call option contract over it. Should you want to write 10 contracts, the underlying shares would cost you $40,000. Not everyone has that much to risk on a single trade.

But what if there was a much cheaper way to realize precisely the same effect as a covered call, but for a fraction of the cost. Would this appeal to you?

Here is how to make it happen:

Rather than purchasing the shares themselves, you buy deep-in-the-money call options with a minimum one year till expiry. These are known as "leap options". For it to be deep-in-the-money the strike price must be more than ten percent of the share price in-the-money. So when it comes to our present illustration, if the underlying stock price is going for $40 then we should buy call options at a minimum $4 in-the-money, i.e. with a strike price of $36 or less.

So let's apply a Covered Call Writing worked example.

We have noticed a stock fall to around $40 recently accompanied by heavy volume and anticipate that in the near term, it should trade in a range. We could buy multiples of 100 shares at $40 or on the other hand, we could buy $32 call options with at least twelve months to expiry. Since they're deep ITM the delta will be close to 1.0000 so most of the value of these options will be intrinsic value with very little time value. $32 call options are $8 in-the-money and they only cost us $9.40 as opposed to the $40 we would've paid for the shares. This means we now have excess funds to buy more of them or risk less capital.

To acquire 10 long call option contracts at this price will cost us $9,400 and not $40,000.

At the same time, we also sell 10 at-the-money call options with a strike price of $40 and only one month to expiry. We receive $130 for each contract we sell, at total of $1300 income.

Likely covered call writing conditions at expiry date of the near month options:

1. The stock price is below $40.

In this instance the sold options will expire worthless and we keep the $1300. We still hold our $32 call options so now we simply sell more ATM call options for the following month out.

2. The share price is slightly above $40.

We then buy back the sold calls and straight away sell further call options at a higher strike price for the next month out, making a financial gain in the process.

3. The share price makes a decisive move upward to around $50

The sold call options will now be deep-in-the-money and we will be exposed by $10 per share, meaning that we will be obligated to sell the shares at $40 even though market price is $50. BUT while doing so, we also hold $32 call options which are now $18 in-the-money.

So we close out both positions. We make $18 profit, as well as a small amount of time value, on the $32 options and lose $10 on the sold $40 options, making a net profit of around $8.75. We have also received a futher $1,300 from selling the $40 call options.

Overall, in one month our covered call writing strategy has produced a profit of $750 (75c x 1000) $1,300 = $2,050 on an investment of $9,400 which is 21.8 percent for the month.

We then decide whether to buy more deep ITM call options based on the now $50 share price (you need at least $5 in-the-money) and sell near month ATM options again, or proceed to another stock. Our decision will be determined by whether we believe the future price direction of this share is to remain steady or fall sharply again.

The above covered call writing strategy is an excellent low risk substitute for the conventional covered call. Your sold options are 'covered' by the deep ITM options instead of the underlying shares themselves.