In a flat to bullish market, most call writers will sell an at-the-money call on the stock they own. the rationale for selling an ATM call is that they have the highest premium in terms of time value. Of course, the option seller can sell at any strike price. What should the call seller do in a market driven by fear such as potential debt defaults, FED changes, financial chaos, etc.? The smart call writer will change their strike price to get more downside protection.
Suppose you want to write a call on a stock that you are concerned about a potential price drop, you can look to write an in-the-money call. The stock is trading at $7.80 per share. You can write the $7.50 call for $0.90. This call has a $0.30 intrinsic value so you are getting $0.60 in time value. As long as the stock is above $7.50 at expiration you keep the $0.60 in time value and the $0.30 intrinsic value. Now you have created a situation where you still make money if the stock declines by 3.85%.
Let’s try another example. The stock is trading at $136.00 per share. You can sell the 135 call for $10.25; the 130 for $13.15; the 125 for $16.40; the 120 for 20.05. You can go down to the 120 call strike to produce a 13% downside protection. Yet you still get a $4.05 time value premium that is almost a 3% return. Now you have created a situation where you still make money if the stock declines 13%.
Considering an average volatility, this is a great way to protect yourself for an anticipated price downturn. While selling ITM calls does not usually realize a return as high as selling ATM calls, it does have the benefit of creating more downside protection for the stock price to fall and still return a profit. You should only sell ITM calls if you are willing to let the stock be called away.
Join the Monthly Income Newsletter voted the best value for option income trading
Follow us on Twitter – @GetRichStayRich