Perhaps you think it's impossible to score another 1,000% gain off this "tech titan" stock. Think again. An unusual strategy lets you virtually "recreate" gains off the biggest companies you thought had come and gone. CLICK HERE to see how it works.
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
- Options Investing: Readers’ Questions Answered
- Covered Calls: Five Steps to Make Profitable Option Trades
- Covered Call Investing: How to Boost Your Bear-Market Income Right Now
|
The Company Set to Dominate a $60 Billion-a-Year Market
$60 billion is spent on cancer treatment in the U.S. - each year. And one company is poised to receive the lion's share of it.
The medical director at the Alta Bates Comprehensive Cancer Center says, "...possibly a third of our cancer patient population will soon be undergoing this [company's] treatment."
Another doctor at the University of Texas MD Anderson Cancer Center says he intends to treat over 1,000 patients a year with this technology.
Here's how you can claim your stake in the company before this cash infusion sends shares soaring.
15 Responses to “Deep-In-The-Money Covered Calls: How to Lower Your Investment Costs & Your Risk”
Comments
**By submitting your comment you agree to adhere to our Comment Policy and Privacy Policy.Check out our selection of daily Investment Research:
 |
 |
Investment U RSS Feed
July 25th, 2009 at 7:22 am
I have some bank stocks i would like to sell covered calls against.
Do you have any tips to help one pick the expiration date for the option? Several are trading in the price that is a little higher than the stock price.
Reply
July 25th, 2009 at 9:14 am
It’s not true that you can trade covered calls in any type of trading account. I have a 403(b) account (with T.D. Ameritrade) in which I’m not allowed to trade covered calls.
Mark
Reply
July 25th, 2009 at 9:32 am
A gem article. Nice, clear, and valuable reminder that options should be a part of every portfolio.
Reply
July 25th, 2009 at 12:00 pm
Your article is really very good for the strategy and the explanation.
I would like it much more if you were cleared two important points:
1.- If the stock has a rally, i.e. 50% or more, you only receive 16%.
2.- If the stock down till cero value, you lost all the money (thinking in GM or Lemhan or others).
3.- If the stock stay below your limit (in the example 7.75) you lost money, i.e., City which is below $4 YTD.
Conclusion, I think you must be more clear about risks.
Best regards,
Dario.
Reply
July 25th, 2009 at 12:52 pm
Karim, this is an awesome article, a part of an awesome series. I have not renewed any subscription that is not a part of a lifetime subscription so I have lost access to your recommendations. I can apply this strategy immediately, perhaps providing enough income to buy your newsletter again.
Thanks again,
Susan Coursey
Reply
July 25th, 2009 at 1:32 pm
Karim, where do you see 1.75 (stated in article) for AUYAL Jan 2010 $9.00 calls?
AUY Jan 2010 9.0000 call
(OPR: AUYAL.X)
Last Trade: 1.54
Trade Time: Jul 24
Change: Down 0.01 (0.65%)
Prev Close: 1.55
Open: 1.55
Bid: 1.45
Ask: 1.60
Day’s Range: 1.45 – 1.60
Contract Range: 1.15 – 3.80
Volume: 27
Open Interest: 1,371
Strike: 9.00
Expire Date: 15-Jan-10
Reply
July 25th, 2009 at 4:13 pm
Please explain how the buyer of this DITM option benefits. Don’t the shares have to exceed $10.75 before he can make a profit by buying the shares from you at $9.00?
Reply
July 25th, 2009 at 9:27 pm
How will I ever know when Bank of America is handling my trust fund ? Robert
Reply
July 26th, 2009 at 3:41 am
Hi Karem,
Whenever I read about convered calls strategies, there never seem to be much information of what to do after expiry. There are 3 possible scenarious, but because of ITM calls, 2 of them are the same:
1) If they get called away due to an the same or an increase in share price , do we buy the same shares again – even if in the case when they are at a higher price? And do we still sell deep ITM calls then?
2) And if they did not get called away, due to a drop in the share price, do we sell covered calls again – but at a lower strike price to get a good premium, or do we sell OTM calls now (but then premium is lower).
For me to have confidence in this strategy is to see the whole plan, including all the possible scenarious.
Regards, PK
Reply
July 27th, 2009 at 6:02 am
Re: Covered Calls
Good article on covering Yamana Gold. Could you show how options can benefit short postions. Using Yamana Gold as an example would be helpful.
Thanks,
GBF
Reply
July 27th, 2009 at 7:29 am
You mention “Lower your cost”. But do you mean to actually lower your purchase price by the option income for Tax / IRS purposes? I was under the impression that if the option you sold expired or you bought it back that it was considered a “short sale”. And if the option was exercised then the proceeds of the option Sale and the Stock strike price were added togehter and that would be your sale price for Tax/IRS purposes?
Reply
July 29th, 2009 at 2:03 pm
Dear Karim,
Please review your Investment U article on Yamaha and using covered calls to lower your costs. When reviewing your section under “Go deep on Yamana” at the bottom of the page you say, “basically, you are willing to own Yamana ect……and then “But if you don’t get the shares etc…. What I read is you are doing an ITM covered call at $9 because you are selling the shares. Therefore, while you have lowered the per share price by the premium, should the shares rise above $9 they will called away. You are not trying to buy them.
Herb
Reply
August 29th, 2009 at 2:07 pm
I used to be a fan of covered calls but I’ve abandoned the strategy – I’ve left thousands and thousands of dollars on the table this year because I sold calls against stocks that skyrocketed.
As for that fat premium on Yamana – it’s because there’s a high degree of uncertainty with the stock. It’s not a giveaway – you’re getting a modest reduction in downside risk for a large elimination of upside return potential.
http://www.longshorttrader.com/2009/08/i-hate-covered-calls.html
Reply
October 25th, 2009 at 3:03 pm
To use 7.75 as basis is an error in paragraph below. I can show you by my example: I buy stock for $10 and sell a $10 call for $5. If closes above expiration my total return is $15 a share which is 50% profit because I use $10 as my basis. Your way is to use $5 as basis ($10 cost minus $5 option premium) which gives 100% profit. It is obvious that I made 50% and not 100% profit.
“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.”
Reply
December 6th, 2009 at 5:31 pm
I do ahve same problem with covered call strategy when strike price is $10.00 plus above the strike price. Is married put may be better strategy? I need your thoghts on this strategy. Thanks. chung hae kim.
Reply