May 21, 2003

What's the real story on deep-in-the-money calls?
by John Brasher, CallWriter Publisher  

Studies consistently have shown that most of the money is made by call buyers on options that are at-the-money (ATM) or slightly out-of-the-money (OTM). But Deeply OTM options pay such a small return they are hardly worth the trouble. Buying deep in-the-money (ITM) options also is risky. Consider the long deeply ITM call: if the stock goes up, the call goes up with it dollar for dollar. But if the stock falls, the deep ITM call falls with it nearly dollar for dollar down to the call's strike price.

So, who is making all the money?

Worse, when the stock price falls below the call's strike, it becomes out of the money and the option will have little value; and all of that will be time value.

Example 1:When the stock is $25, you buy the 20 Call for $5.30. You're only paying $0.30 in time value, because $5.00 of the premium is intrinsic value. If the stock falls to $20, the 20 Call will be worth only pennies: all time value, no intrinsic value. Example 2:  When the stock is $25, you sell the 20 Call for $5.30. Sounds like a big premium in your pocket, right? Not really! You're only getting $0.30 in time value. If the stock falls to $20, the 20 Call will be worth only pennies: all time value, no intrinsic value. However, the $5.30 premium protects against a drop to $19.70.

Selling (not buying) deep ITM covered options makes excellent sense, but if and only if the premium includes lots of time value. The reason is that time is the option writer's friend, because time terminates his trade risk and locks in his profit from writing the option. [We aren't fans of buying deeply ITM calls. It's too big a gamble on the stock's movement. And if you are that sure of a decline, buying a put one or two strikes below the stock price would be much cheaper.]

Deeply ITM options usually are mostly, and sometimes all, intrinsic value. Remember, the amount an option is in the money is its intrinsic value. When the stock is $20, the 15 Call is $5 in the money. An option that is all intrinsic value is said to be trading at parity. Many option books are written to make it sound as though the intrinsic value is the "good" value and that time value is flaky or undependable. Not so! It makes no sense whatever to write covered calls where the options are at parity. Why? Since most of the premium is intrinsic value, you are getting paid with your own money! All covered call returns are calculated on the amount of time value. In our example above where the option was sold for $5.30, the return is the $0.30, not the $5!!

Finding a Deep ITM option with a a high time value is like finding money on the sidewalk. The time value portion of the ITM premium is your profit. Selling the Deep ITM covered call (when it carries a lot of time value) gives you both a high return and significant downside protection if the stock drops. You should only write deep ITM options that carry a high proportion of time value.

Typically the return on an ITM covered call is 2% - 4% per month. This annualizes to as much as 48% without compounding your profits through reinvestment. This is a high return for what is considered a conservative strategy. And it is for investors who are not interested in retaining the stock in which they sell covered calls. (All trades should be properly researched with appropriate stops in place.)

When calculating a return on an ITM covered call you should ignore the intrinsic portion of the premium and calculate your return based on the time value portion of the premium. If you use lists or a covered call calculator, make certain that they calculates only the time value as the return on the covered call. CallWriter's Real Time Lists™ and Position Management Calculator™ are specifically design to show you the exact return you will receive without margin. (Be aware that many lists on the web use margin to inflate their returns.)

And our exclusive real-time Deep In the Money lists are a great place to find these winning plays. Why? These new lists only feature plays with lots of TIME VALUE, which is where the real returns are for the deep in the money call writer. So when you see fat returns on the new lists, they're REAL returns on your dollars! And only CallWriter has them.

Good luck and good trading!