In-The-Money Covered Call

[Igor 10]

Traders who implement an ITM covered call strategy writes (sells) a call option for leverage against potential losses on owned shares. They also gain a steady premium when the market rises. The strategy involves writing a call option ITM and buying the same number of regular shares of the underlying asset. A long call strategy guarantees traders a steady return in bull markets. Premiums received from writing the call cut losses, if the price of the underlying asset falls.

 

Definition of ITM, ATM and OTM for Covered Calls

There are three ways to define the relationship between an option's strike price and the market price of its underlying asset. Understanding the differences between the terms is important when considering the returns involved in implementing a covered call strategy.

 

 

ITM - In The Money: The underlying asset's market price is more than option's strike price.

Example:

- Call Option XYZJan45 (strike price $45)

- XYZ is trading at $50

 

ATM - At The Money: The underlying asset's market price equals the option's strike price.

Example:

- Call Option XYZJan45 (strike price $40)

- XYZ is trading at $45

 

OTM - Out of The Money: The underlying asset's market price is less than option's strike price.

Example:

- Call Option XYZJan45 (strike price $40)

- XYZ is trading at $55

 

How to Implement a Covered Call Strategy (ITM)

 

XYZ is worth $50 (market price)

1) Trader buys 100 shares of XYZ preferred stock and pays $5000.

2) Trader writes (sells) a call option: XYZJan45($7)

- 100 shares of XYZ stock

- Strike Price $45 (ITM), expiring in 30 days

- Premium Cost of $7

3) Trader receives $700 in premiums (100 x $7 (premium cost)).

Total Investment cost: $4300 [$5000 (paid) -$700 (premiums collected)]

 

Result one: XYZ hits $55 (ITM).

The call buyer exercises his or her right to buy 100 shares at $45, paying $4500 for the seller's assets. After adding the $200 in premiums received, the trader's covered call strategy results in a $200 profit [$4500 (received) - $4300 (Paid)].

 

Result two: XYZ hits $45 (ATM).

The call buyer lets the option expire and the writer keeps the premiums paid. The shares held by the writer loses $500 in paper value [$5000 (paid) -$4500 (worth on strike date)], but since the writer received $700 in premiums, he or she still makes a profit of $200. [$700 (premiums collected) -$500 (loss)]

 

Result three: XYZ hits $40 (OTM).

The call buyer lets the option expire and the writer keeps the premiums paid. The shares held by the writer loses $1000 in paper value [$5000 (paid) -$4000 (worth on strike date)], but since the writer received $700 in premiums, his or her loss reduces to $300. [$700 (premiums collected) -$500 (loss)]

 

Advantage and Disadvantage of Implementing a Covered Call Strategy:

 

Pluses: The upside to this type of strategy is that the investor will always make a profit when the price of the underlying asset rises. Another advantage in using a covered call strategy is that the investor can also profit from a drop in price of the underlying asset. Writing the call option leverages the investment against market downturns, and it gives the trader a cushion for reducing his or her losses.

 

Minuses: The downside in using covered call strategy is that the method limits an investor's profits. If the underlying asset's market value takes off, the trader cannot take advantage of the gain because he or she must sell assets at a fixed price after assignment.