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.

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Deep In-The-Money Covered Calls

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The strategy 

  • is often employed by holders of long term equities who are looking to milk some extra income out of certain stocks in their portfolio. 
  • Other times,  traders will simply select a single  equity about which they have formed a bullish bias and undertake a covered call campaign around that stock.


Like every trade, there is an upside and a downside to the covered call.  If the trader is  “too” wrong and the stock  sells off substantially, the trade will be a loser–at least in the short term–because the loss on the shares will outstrip the gain on the short call.  If the trader is “too” right, the covered call will limit the trader’s  upside to the appreciation that the stock will enjoy up to the strike price of the short call.  The trade will be a winner, but not as big a winner as it would have been to have simply been long the stock or long a deep in the money call (a “synethetic” long  stock position).  However, if the trader is a little wrong or a little right, the covered call strategy will easily outperform a simple long position in the stock and can turn losing share holdings  into winning trades or flat boring equity positions  into outstanding  winning trades.


In this case, Lee actually commenced his campaign cleverly by selling a naked October ’10 $30   put on GMCR, picking up $138 of option premium which he pocketed when GMCR was trading at $34 last September.  GMCR  then  fell below $30 and he was assigned 100 shares of GMCR    upon the expiration of his put.  So Lee was off to a good start,  picking  up $138 of income on a stock that he was willing to own at $30 anyway.


Over the next three months, Lee cleverly milked his $3000 investment in GMCR stock selling slightly out-of-the money  calls and puts around his core GMCR long stock position then  buying them back as the stock fluctuated in price, buying back   the calls and puts  when  they shrunk in value to a fraction of their original sale price.


The day before GMCR’s  monster one day $18 point rally last week, here was Lee’s position:   in addition to holding  the GMCR  shares as they appreciated 45% above his original purchase price (the $30 per share that he shelled out when he was assigned the shares last October)   Lee milked another 10%  from his shares by skillfully selling calls and puts around his core long position.


The day after the monster up move, Lee’s “campaign” was up 58% in six months–a VERY successful covered call campaign.


It is true that if Lee had  simply purchased the GMCR shares at $30, his appreciation at the end of last week would have been closer to 100%.  However, had the GMCR shares appreciated more gradually, the covered call approach  would have  almost certainly continued to outperform a buy and hold shares strategy handily. Again, if the trader is “too” right, the covered call strategy will be successful, but may or may not be as successful as buying and holding the shares.


So first off, I’d argue that  there is nothing  to”repair”. This trade is a tremendous success.  Lee just has to make a decision as to where he wants to go from here with this campaign. If Lee has achieved his planned objective on the trade or believes the stock is due for a correction, he can simply cover the call and sell the shares simultaneously locking in his excellent gain.


On the other hand, Lee  may think that  the stock has further upside.  If so, he can buy back the call, take the loss on the call (while still holding shares that are up almost 100%)  and sell an out-of-the money call such as the April 65 or the June 65 or even 70. In this case, even if the stock sells off a bit, Lee could be in a better position than he is today because of  his receipt of the  new  call premium he collected–it would all depend upon how steep the sell off is,  and   its timing.   On the other hand, if Lee is stays in the trade and his further  bullish bias is correct,  the P and L of  his “campaign” will continue to improve.


Lee, great job on your covered call campaign!  You don’t need a “repair” at all–you just need to decide whether your capital is better employed in a different trade with more potential upside and less potential downside, or whether you think your best risk/reward trade-off remains in remaining in the GMCR campaign.


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
Covered calls are profitable unless the stock moves down below the break even price.  

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.

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