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Writing Out-Of-The-Money Covered Calls

If you are bullish on a specific stock, then you should consider writing an out-of-the-money (OTC) covered call.  This type of call includes a strike price that is above the current stock price.  You still get a call premium but is generally less than an at-the-money call.  But you also get the potential of stock appreciation because of the higher strike price of the call sold.  This creates a situation for potentially two income streams from one trade.

This trading strategy works best when you can confirm the stock being in an uptrend or if the stock is bouncing off a support level.  A support level would be something like a 50-day moving average or even a Bollinger Band that has been stretched on the bottom.

The key to this strategy is to be right about the stock price moving higher in the near future.  Due to the OTM call offering less premium than an ATM and having a low delta, they can be slow to lose value on a stock pullback.  This strategy should be used in special situations or during a slow moving bull market.

Also, you want to avoid this strategy when he stock has gapped up until the new price range is confirmed.  Stocks that gap up usually pull back before they stabliize in a new trading range.  However, a stock slowing moving up is a good opportunity for OTM writes.

This strategy works well when you have a down-day in the stock or market.  The stock price decline will usually be temporary down and will bounce back in a few trading days.  You need to be sure the market decline is not a permanent correction that will be sustained for months.

This is a good strategy for stocks you do not want called away in a flat market.  You can still get an increased profit if the stock price is above the entry price at expiration.  Then, you get an even bigger return if you get called out at the higher call strike price.

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Writing Deep-In-The-Money Covered Calls For Protection

The conservative covered call writer is seeking downside protection and income from premium.  This investor places more value on protecting capital and is not concerned about their stock being called away.  This covered call investor will sell calls that are deep-in-the-money (ITM).  This is a good strategy when the market uncertainty increases and there is increasing worry about a market correction.

For example, if XYZ is trading at $53.00 then a deep ITM call will be sold at the 45 strike price.  This call is $8.00 ITM and provides a 15% downside protection.  With a stable stock like XYZ, it probably will not go below the 45 strike price during a market pullback.  In fact, XYZ has not been below $45.00 in the last three years.

The trade-off for selling ITM calls is that the returns will be lower as the majority of the call premium is intrinsic value.  The method to the madness is that these calls offer more downside protection in return to accepting a lower time value of premium.  ITM call writes can be a very successful strategy when used on large-cap stocks during a martket pullback.

There are many covered call traders that suggests they made a higher return over a long time period for several reasons:

  • It is not that difficult to find a 3% return with 30 days remaining on high quality stocks;
  • The stocks will be assigned at expiration so you are never stuck with a stock that is down;
  • ITM calls have a higher delta so they lose value closer to the stock.  You can easily roll down your strike price without a loss;
  • Trading the short call is more profitable due to the high delta.  Here trading refers to buying back the call on a price dip and write them again on the bounce back.

The ITM writer should concentrate on large-cap, high quality stocks as there is never a reason to trade poor quality stocks regardless of your strategy with ITM calls.  The one item of note is that this strategy is not the best in a rising bull market unless you have a high risk avoidance to a potential trade loss.

A variation of this trade is to use it when volatility is high such as in the financial crisis in 2009.  The high volatility will increase the amount of premium and return.  You can use this strategy when there is a pending event such as an earnings release but not as a speculation trade.  the key is to use this strategy with large-cap, high quality stocks.

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