Why Would Anyone Sell "In-The-Money" Covered-Calls?
Writing "covered" calls has been a popular portfolio hedging technique almost since listed options were introduced to the equity markets. While it's impossible to know which method has enjoyed greater use, retail investors have traditionally focused on out-of-the-money (OTM) call options because they offer additional income as well as the possibility of capital gain. This approach is certainly viable in situations where the outlook for the underlying issue and/or the resultant cost basis of the position warrants additional risk, but it also has a lower probability of success. In addition, any upside potential is dependent on favorable stock movement thus the value of an out-of-the-money covered-call portfolio will be much more volatile on a relative basis.
A More Conservative Alternative
At times, the process of comparing different time frames and strike prices for a covered-call position may seem overwhelming to less-experienced traders. However, the steps involved are much simpler when the yield is calculated based on the share value remaining unchanged. Using this method, there are no assumptions about future market trends and a more accurate (month-to-month) return can be determined. In his book, "Options As A Strategic Investment," Larry suggests looking for positions that offer a minimum profit of only 1%-2% per month with downside protection of at least 10%, and this ratio is generally available only through the sale of in-the-money call options. Obviously, these guidelines are very conservative hence more adept market participants often spread their holdings across a variety of ITM and OTM positions to balance portfolio risk with potential return on investment. In the end, determining the most appropriate option (strike) to sell in a covered-call position is simply a matter of identifying one's personal risk versus reward attitude.
Investors who have never sold in-the-money calls may be concerned about the possibility of an unexpected assignment but that's not a problem when stock ownership is secondary to achieving consistent profits. In fact, having the stock "called" early will actually increase the position's yield by providing the maximum possible gain in a shorter time frame. In those cases where an exit or adjustment is warranted prior to the expiration date, the sold (short) calls can always be repurchased, thus eliminating the need to retain the stock. An investor can also roll forward and/or down to longer-term options in order to lower his cost basis or attempt to rescue a losing position. Although the sale of (ITM) covered-calls is inherently a conservative strategy, an individual's success depends greatly on effective stock selection and the use of proven money-management techniques to limit losses when they occur. Technical analysis is commonly utilized to identify primary trends and areas of recent buying support, which can assist in establishing the correct entry and exit points. There are also various stop-loss methods an investor can employ in position management: a fixed percentage of one's overall portfolio value, a specific dollar amount, a violation of a technical trend-line, etc. It really doesn't matter whether the method of position management is mental or mechanical; the key to earning regular income is adhering to a system that will generate reasonable, consistent profits and minimize draw-downs from losing trades.
The proficient covered-call writer is always striving to find positions that offer a reasonable balance between profit potential and downside protection. In the Covered-Call System, we offer a wide range of candidates suitable for a variety of investors. However it is important to remember that all of the positions are provided simply to supplement the search for profitable opportunities. All forms of trading have risk, consequently it is imperative that each individual reader perform their own due diligence and, as with any investment, decide if the published selections meet his or her personal investment criteria and risk-reward outlook for favorable covered-call positions.