Understanding In-the-Money Covered Calls
In the world of options trading, in-the-money covered calls emerge as a strategic play where investors sell call options against stocks they own. This unique strategy involves a strike price lower than the current stock price, offering a blend of downside protection and calculated income potential.
Decoding the Basics
Defining In-the-Money (ITM) Calls
- ITM covered calls occur when the call option’s strike price is less than the current stock price.
- For instance, if a stock is trading at Rs 53.50, any call option with a strike of 53 or less would be “in the money.”
Know: Introduction to Call and Put Options
Outcome Scenario
- If the stock price remains above the strike price at the option’s expiration, the option is exercised, and the investor sells the stock at the strike price.
Investor Appeal
- Income-oriented investors favour short-term ITM-covered calls for their built-in downside protection and the ability to calculate potential returns if the option is exercised.
Illustrating with an Example
XYZ Stock Scenario
Buy 100 XYZ at Rs 44.25: Cost Rs 4,425 Sell 1 lot Nov 42 call at Rs 3.4: Receive Rs 340 (Assuming Lot size of 10) Net debit: Rs 4,085 (Break even if XYZ at 44.25 - 3.4 = 40.85)
- Let’s consider XYZ stock trading at Rs 44.25.
- An investor buys 100 shares at Rs 44.25 (Rs 4425) and writes a November 42 call option for Rs 3.40 (Rs 340).
- Net out-of-pocket cost: Rs 4085 (Rs 4425 – Rs 340).
Downside Protection
- Even if XYZ falls to Rs 42 (the option’s strike price), the investor makes Rs 115.
- The Rs 2.25 (Rs 44.25 – Rs 42) downside protection provides a safety buffer.
Risk Awareness
- If XYZ is below the net debit (Rs 40.85) on expiration day, there’s a potential loss.
- The call option offers partial downside protection (5% in this case).
Upside Potential
- If XYZ rises, the maximum profit is Rs 115.
- Covered calls limit upside potential but offer a structured approach to returns.
Summary:
Option exercised, you lose stock and receive Rs 4,200 Net debit was Rs 4,085 Profit on trade = Rs 4,200 - Rs 4,085 = Rs 115 Return = (115/4085) = 2.8% Return annualized = 32%
Strategies for Success
Potential Returns
- Covered calls may cap upside, but monthly returns of 2% or more can lead to substantial long-term gains (24% annually).
Diligent Stock Selection:
- When searching for ITM covered calls, prioritize stocks you wouldn’t mind owning at the net debit price. Research and due diligence are essential.
Conclusion: Mastering the Art of In-the-Money Covered Calls
In-the-money covered calls represent a strategy that investors deploy to harness income while safeguarding against potential downturns. The delicate balance between downside protection and capped upside potential makes this approach a calculated dance in the world of options trading.
