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Financial Literacy

Deep-In-The-Money Covered Calls: How to Lower Your Investment Costs and Your Risk

Deep-In-The-Money Covered Calls: How to Lower Your Investment Costs & Your Risk

by Karim Rahemtulla, Advisory Panelist
Saturday, July 25, 2009: Issue #1050

Recently, I explained the nuts and bolts of covered call investing – a bullish strategy that focuses more on returns than it does on risk. In my column, I used the example of Yamana Gold (NYSE: AUY), showing you how to reduce your cost when buying stocks – and thereby increasing your upside potential if the shares move higher.

Today, we’re going to kick things up a notch and explain how you can cleverly take the same covered call strategy and add a twist, by using deep-in-the-money covered calls. When you do so, you can achieve more consistent returns over time, while also protecting your capital.

Simply put, I’m going to focus on mitigating risk…

Getting Deep-In-The-Money… An Unconventional Covered Call Strategy

With a conventional covered call strategy, you buy regular shares of a stock and then sell a call option against them, whose strike price is higher than the current share price. Your aim is that the shares will move higher and will get called away at expiration for a profit.

While this does happen, it doesn’t occur as often as you might think. Plus, it usually only happens during an upward moving market.

However, with the deep-in-the-money (DITM) covered call strategy I’m focusing on today, we’re not expecting the shares to move higher. In fact, we don’t even need the stock to trade higher in order for us to make money. It can actually go lower (sometimes much lower) and we’ll still make money.

Pretty compelling, right?

In short, what we’re seeking is safety. And to get it, we need to employ a strategy that protects us much more often than not.

So how about a win/loss ratio of 75%? That’s the performance the deep-in-the-money strategy recorded over the past 13 years that I’ve used it. That means we’ve only lost money or broken even 2.5 times out of 10. At all other times, we’ve made money, usually notching up market-beating returns.

Just yesterday, in fact, in my Strategic Income service, we closed out two winning positions – 13% on Wells Fargo (NYSE: WFC) and 33% on Goldcorp (NYSE: GG) – positions we initiated before the market’s collapse.

Here’s how it works, using the Yamana Gold example again. Recall that in last week’s example, we bought Yamana under $9 and sold the $10 (out-of-the-money) calls against our position.

How To Use Deep-In-The-Money Covered Calls

This time, we’re going to buy the same Yamana shares. But instead of selling the $10 calls, we go deep-in-the-money instead.

  • Buy 1,000 shares of Yamana at $9.50 – a total outlay of $9,500.
    • Sell 10 contracts of the January 2010 $9 calls (AUY-AL). Trading at $1.75 per contract, you receive proceeds of $1,750 (remember that each contract contains 100 shares, so it’s $1.75 multiplied by 100 = $175. Then $175 multiplied by 10 = $1,750).

 

    • Your cost for Yamana shares is now $7.75 ($9.50 minus $1.75) – a full 18% below the current price. This is the crucial number. If Yamana closes above $7.75, you’ll be profitable.

 

    • If Yamana closes above $9 at expiration, you’ll make 16%. You arrive at this number in this way…$9 (strike price) minus $7.75 (cost) = $1.25 (profit).$1.25 divided by $7.75 = 16%.If the stock moves higher, your returns are capped at 16%, regardless of where it goes.

 

  • Even if Yamana shares stay at today’s level, you’ll still make 16%. So you have an additional chance of profiting from the trade, versus just one with a straight long strategy, which requires the shares to move higher.

Additionally, you reduce your cost of ownership in Yamana to $7.75.

Basically, you’re saying that you’re willing to own Yamana at $7.75 – 18% below current prices. But if you don’t get the shares at that price, then you want to be paid for trying – something that happens nearly 80% of the time.

What to Remember When Using DITM Covered Calls

Here are a few things to remember whenever using deep-in-the-money covered calls:

    • You can execute a deep-in-the-money covered call strategy in any trading account.

 

    • If you do end up with the shares, you can sell additional calls against your position to reduce your cost even further. The goal is to own the shares for zero dollars or even a negative cost over time.

 

    • Always make sure you employ position sizing – i.e. never put too much in a single investment.

 

  • At expiration, if the shares are trading above your strike price, they’ll be automatically taken from your account.

That’s all for this issue.

Karim Rahemtulla


About

With more than 20 years of experience, Karim has mastered the subtle art of options trading. What we admire about him is his ability to score huge gains while minimizing the massive amount of risk that often comes with options. Beyond his expertise in options trading, he is also the author of the best-selling book Where in the World Should I Invest? He publishes weekly about smart speculation in his latest free e-letter, Trade of the Day.

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