Bookmark and Share Oct 19, 2010 In The Money Covered Calls

In the money covered calls are those where an investor has sold a call option against stock he owns (hence, it is "covered") where the strike price of the call option is less than the current stock price (so it is "in the money"). For example, if a stock is trading at $53.50, then any call option with a strike of 53 or less would be "in the money".

in the money covered callsIf the stock price stays above the strike price through the option's expiration date then the option will be exercised and the investor will be forced to sell his stock at the strike price. Income-oriented investors generally like writing short-term in the money covered calls. It's a popular strategy because there is some downside protection and they can calculate in advance what their return will be if the call option is exercised and the stock is taken away.

For example, let's say you like LULU (Lululemon Athletica, a clothing retailer). Stock is trading at 44.25 so any option with a strike of 44 or less would be in the money. You could buy 100 shares of stock at 44.25 ($4425) and then write a November 42 call option for 3.40 ($340). That means you receive $340 today and your total out-of-pocket costs to put this trade on are $4085 ($4425-$340).

Buy 100 LULU at $44.25: cost $4425
Sell 1 Nov 42 call at $3.40: receive $340
Net debit: $4085 (break even if LULU at 40.85)

Now, if LULU is over 42 on Nov 20th (when the November options expire) then it will be called away and you will receive $42/share, or $4200:

Option exercised, you lose stock and receive $4200
Net debit was $4085
Profit on trade = $4200 - $4085 = $115
Return = (115/4085) = 2.8%
Return annualized = 32%

Note that even if LULU fell from its current 44.25 down to 42 (the strike price of the option you sold) you would still make the $115. That's because you have $2.25 ($44.25 - $42) of downside protection from the in the money covered call. However, if LULU was below your net debit (40.85) on expiration day then you would have a loss. The call option gives you some, but not total, downside protection. In this case it gives you 5% protection (2.25 / 44.25); LULU would need to fall by more than 5% in 32 days before you'd have a loss.

Likewise, if LULU rises then the most you will make is the $115. That's the nature of covered calls -- you get some downside protection but at the cost of putting a cap on your upside. But if you can consistently earn 2% or more per month then you will doing great in the long term (that's 24%/year).

When searching for in the money covered calls you should not just chase the highest yield, but instead do research and only get involved with stocks you wouldn't mind owning at the net debit price of the transaction, because if you do enough covered call trades then that will happen with some of your trades.

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