Deep In The Money Covered Calls
Deep In The Money Covered Calls is an options strategy where the strike price of the call option is significantly less than the current stock price.
Covered Call | Covered WRite |Bullish
Deep Out of the Money Calls
How do you profit from deep out of the money calls
When you buy a stock option, the option contract requires you to choose a strike price and expiration. You are betting that your stock will surpass your strike price by your established date.
A strike price for calls is considered in the money if it is below the stock price. It is at the money if it is at ( or around ) the stock price. And it is considered out of the money if it is above the stock price.
All things being equal ( no change in volatility for example ), the odds of success decrease as you progress from ITM to ATM to OTM to deeper OTM stroke options. The reward, however, can be significantly higher as you move through the progression. That is, some traders might want to bet on a deep OTM option for a lottery payout despite poor odds.
Returns of this magnitude shouldn’t happen this frequently. But they do because the Black-Scholes model isn’t equipped to properly value DOTM call options on high momentum names.
The strategy:
- buy low delta calls 4-12 months out in time on a high momentum stock
if you’re willing to go against your innate biological wiring it’s possible to make a good chunk of change by doing the opposite — buying deep out-of-the-money (DOTM) options that seldom win. As long as the winners earn multiples of the losers it’s possible to walk away with a profit — despite the low win-rate.
To win as a buyer you must carefully select DOTM options that have the best chance of upsetting the implied distribution of the Black-Scholes pricing model. Black-Scholes for the most part works pretty well. But it has a flaw, the model assumes that momentum doesn’t exist. This assumption holds up just fine in the short-term. But it breaks down badly in the long-term.
As market practitioners we know that momentum, of course, does exist. And we know also that momentum becomes even more pronounced the longer the time-frame.
So there’s a profitable trading opportunity if we buy DOTM options with many days left to expiry and allow the underlying enough time to drift pass the strike price.
Jim Leitner — one of the most successful global macro traders of all time picked up on this long ago. He talks about the mispricing of long-dated options in his 2006 interview with Steven Drobny (emphasis mine).
Longer-dated options are priced expensively versus future daily volatility, but cheaply versus the drift in the future spot price. We need to make a distinction between volatility and the future drift of the currency. Since the option’s seller (the investment bank) hedges its position daily, it makes money selling options. Since some buyers do not delta hedge but instead allow the spot to drift away from the strike, they make money on the underlying trend move in the currency. So both the seller of the option and the buyer make money. The profit for the seller comes from extracting the risk premia in the daily volatility, and for the buyer it comes from the fact that currency markets tend to exhibit trending behavior.
If the option maturity is long enough, trend can take us far enough away from the strike that it’s okay to overpay.
Hot stocks have a tendency to drift (ie, trend) for long periods. They don’t follow a random walk as the Black-Scholes model assumes.
Knowing this, our go-to DOTM option strategy is to buy low delta calls 4-12 months out in time on high momentum stocks.
A momentum stock can cause DOTM calls to appreciate as much as 64x of the original price…Here’s an example of that from one of our stock picks from the summer of 2017.
The Black-Scholes model massively mispriced these calls. A return of that magnitude should rarely occur. But we see it happen again and again in the long-dated DOTM calls of high momentum stocks.
DOTM calls on momentum stocks are producing once-in-a-decade returns every year.
Returns of this magnitude shouldn’t happen this frequently. But they do because the Black-Scholes model isn’t equipped to properly value DOTM call options on high momentum names.
The two most important reasons for setting up a covered call:
- Reduce cost basis of buying a stock
- Hedge an existing stock portfolio if you already own 100 shares of a stock.
- Covered calls are profitable even if the stock down’t move
A covered call reduces the cost basis of buying a stock by accepting a premium for selling a put above the stock price.
If you were to sell the 105 put for a premium of 5 dollars. The collected premium effectively lowers the cost basis of buying 100 shares of the stock at 100 dollars to buying the 100 dollars of shares at 95 dollars. The break even price is now 95 dollars.
The answer is obviously subjective. But most traders defines “deep in the money” as:
A strike price that is more than 10% below the stock price or
A strike price that is less than the first available in the money strike or
a strike price is less than 2 strikes in the money
If you have a stock XYZ that is selling at 100 dollars. And you have strikes available at 90, 80, 70, and 60 dollars, then the first strike in the money would be 90 dollars.
A deep in the money strike, if defined as a strike that is lower than the first available strike price, would be a strike price of 89 dollars or less.
The main advantage of a deep in the money call option is the safety you get with an increased downside protection * intrinsic value.
The main disadvantage of a deep in the money call option is the addition of too much time premium and you give up all of the upside potential.
The strategy of selling deep in the money calls is used when:
You want to sell your stock. By selling a deep in the money call against a stock that you already own, you will gain time premium, but you will no doubt forfeit your stock if the stock does not go down below the strike price. If the stock price goes down but not quite to the strike price, you can buy back the contract and keep part of the premium.
You want to hedge your gains after a huge run up in the stock. If you think that a stock is over-extended after a big run-up, you can hedge your gains buy placing a deep in the money covered call. Once the stock pulls back and below the strike price, you can buy back the option and keep the premium. If the stock doesn’t pull back, you can buy back the option but prior to expiration. Don’t wait too long.
The most common reason traders use a deep in the money covered call is to employ a buy-write strategy to gain a calculated yield. A trader will buy a stock and sell a deep in the money covered call against it. If the stock price remains above the strike price, the stock will be called away, but you will have gained the premium on the transaction at a calculated yield.
- The stock must have positive momentum
- See if you can narrow down a stock that is a leader in its sector
- See if you can find a clear recent breakout
- The company must have exciting fundamentals
1. The stock must have positive ( preferably explosive ) momentum
Investor’s Business Daily is my primary source for momentum stocks. They have a leaderboard where they present their favorite momentum players with good fundamentals. I’m sure you can find other similar lists. You can use these list to screen stocks that you might want to use for this strategy or you can simply run a momentum screen to find stock that have the best 6 to 12 month returns ( knowing that historical trends do not necessarily translate to future trends ).
Do not buy equities index or commodity; neither are explosive.
2. Narrow down your list of stocks to stocks that are leaders in their sector.
Even better than finding an outperforming stock is to find an outperforming stock within an outperforming sector. The outperforming sector will feed the momentum of your chosen stock.
3. Narrow down your list if possible to stock that have had a clear recent breakout.
Pricing models do not immediately price out breakouts properly especially in their deep out of the money options. The models simply haven’t worked out how to price out long dated options fast enough. Prices remain what they were when the stock was more stable and less volatile. Stable and less volatile imply lower premiums. Breakouts from consolidations act as technical catalysts that propel a stock higher and none of the trend is yet priced into the options.
4. The company must have strong fundamentals
Remember that options trading is a balance between risk and reward. You can significantly lower your risks, particularly in buying deep OTM longer dated options by choosing companies with good fundamentals, strong revenue and free cash flow growth.
- Make sure the implied volatility of the stock is lowish
- Make sure that the stock is liquid
- Make sure you have the directional movement of the stock correct
1. Make sure the implied volatility of the stock is lowish.
The premise of the deep OTM Call strategy is that you can outperform the pricing model of the Black-Scholes pricing algorithm and its inability to properly account for momentum as a variable.
If the stock has a high implied volatility ( higher than 40 ), then the premium prices are already elevated. Remember that premium prices rise and fall with implied volatility. An elevated implied volatility is not usually sustainable over a long period; probability dictates that the implied volatility will eventually drop.
Translation: buying a stock in a period of high volatility implies that the implied volatility will most likely fall with time, momentum will likely stall and threaten the ability to reach the necessary strike price, and the premiums will fall with the fall in implied volatility.
2. Liquidity will dictate the strike price
Our ideal parameters for a deep OTM Call strategy is to buy a stock approximately 100 days out and has a delta of 15 or less. The trick is to identify stocks with these parameters that also have buyers and sellers. If you have no sellers, then you can not buy the option.
Bullish Option
Strategies
Same risk profile as a short put
Bearish Option Strategies
Same risk profile as a short put
Neutral Option Strategies
Same risk profile as a short put