deep in the money calls 4, Deep In The Money Calls

We've discussed in the money covered calls before, but given the market's recent run up, we thought it timely to revisit the subject for those of you who feel we're a bit overbought and are looking for some safety. If you do any buy-writes next week with Feb expirations you may want to consider deep in the money options.

Deep In the money calls are those where the strike price of the call option is significantly less than the current stock price.

What is "significantly less"? In lay terms, most investors consider anything that is more than 10% in the money to be "deep in the money". The IRS definition of deep in the money is any option with less than 90 days until expiration where the strike is less than the first available in the money strike, or any option with more than 90 days until expiration where the strike is less than 2 strikes in the money.

For example, if ABC stock was at $53 and had strikes available at $50, $45, $40, and $35 then the 1st strike in the money is $50. So, according to the IRS, options less than 90 days would be "deep" at strikes $45 and below, and options with more than 90 days would be "deep" at strikes $40 and below.

The advantage of selling deep in the money calls is the safety you get with increased downside protection (intrinsic value). The disadvantage is that there may not be much time premium and you give up all of your upside potential. (And note that buying deep in the money calls is a completely different strategy, and not covered here.)

When To Use The Deep In The Money Calls Strategy

1. You want to sell the stock. By selling a deep in the money call against it you can get a little extra time premium for stock you were going to sell anyway.

2. You've had a big run up in the stock and want to protect recent gains. If you think the stock is due for a little pull back but you don't want to sell the stock then sell a deep in the money call against it. Once the pull back takes place you can buy the option back (and you've protected yourself from the pull back). If the stock doesn't pull back and you want to keep it then you will have to buy the option back (potentially at a loss) prior to expiration.

3. You want to do a buy-write so you can earn a higher yield than what you can get in cash. Probably the most common reason for selling deep in the money calls. Unless the stock finishes below the strike price at expiration you'll be able to calculate in advance what your yield will be as you wait for it to be called away. Be careful not to do this if earnings will be released before option expriation (too much volatility).

Selling Deep In The Money Calls Example

Let's say you like McMoRan Exploration (MMR, oil & gas company). Stock is trading at 16.91 with $1 increment strikes so any option with a strike of 15 or less would be deep in the money. You could buy 1000 shares of stock at 16.91 ($16910) and then write ten Mar 15 calls for 2.45 ($245). That means you receive $2450 today and your total out-of-pocket costs to put this trade on are $14460 ($16910-$2450).

Buy 1000 MMR at $16.91: cost $16910
Sell ten Mar 15 calls at $2.45: receive $2450
Net debit: $14460 (break even if MMR at 14.46)

Now, if MMR is over 15 on Mar 19 (when the March options expire) then it will be called away and you will receive $15/share, or $15000:

Option exercised, you lose stock and receive $15000
Net debit was $14.46
Profit on trade = $15000 - $14460 = $540
Return = (540/14460) = 3.7%
Return annualized = 32%

Note that even if MMR fell from its current 16.91 down to 15 (the strike price of the options you sold) you would still make the $540. And if it fell to $14.46 you would break even. That's because you have $2.45 of downside protection from selling deep in the money covered calls. However, if MMR was below your net debit (14.46) on expiration day then you would have a loss. The call options give you some, but not total, downside protection. In this case they give you 14% protection (2.45 / 16.91); MMR would need to fall by more than 14% in 43 days before you'd have a loss.

If MMR at 15 makes you nervous then you can do the same thing with the Mar 14 options instead. Your annualized rate of return drops to about 25% (instead of 32%) but you gain an extra $1 of downside protection (so total protection would be over 20%, compared to the 14% you got at the 15 strike, and an annualized rate of return of 25% is still very good).

Software Screener For Deep In The Money Covered Calls

Born To Sell has a special screener that finds high yield deep in the money candidates. It's called Max Protection. You specify the minimum annualized rate of return you want, say 24%/year, and then it sorts all deep in the money covered call candidates that have a rate of return greater than 24% by downside protection (so the ones with the most protection are on top). You can then use other standard filters to do things like remove all candidates that have earnings before expiration, for example. Big time saver! Here's a demo:

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