August 25, 2005

Why Write In-the-Money Covered Calls?
by John Brasher, CallWriter Publisher

A common question I get is whether or not it is better to write in-the-money (ITM) covered calls. The premium on deeply ITM calls presents a powerful siren song for many traders. This issue will briefly discuss the benefits of writing in the money, and some of the tradeoffs that are involved.

I get asked a lot whether writing deeply in-the-money covered calls is safer than writing at-the-money (ATM) or out-of-the-money (OTM) calls. There is something to the notion that deeply in-the-money (ITM) calls are "safer" than ATM or OTM calls, although I really believe the answer has more to do with one's trading style than any trading absolutes. There are three main points to consider here: downside protection and return, ease of trade management, and the ease of trade monitoring. Covered calls that are deeply ITM (meaning, in my view, 10% or more ITM) offer large premium that provides a lot of downside protection, and so are "safer" from this standpoint.

I would say that writing ITM is more conservative than ATM or OTM writing, but not necessarily safer. Deeply ITM calls also almost always present a lower return than ATM or OTM calls; these days substantially less. In fact, as I write this, it is difficult to find a deeply ITM call that is paying more than 5% with 30 days left until expiration, and even a 5% return can be hard to find at the 30-day mark. The tradeoff for the large downside protection is a much lower return. But I have to emphasize this: writing ITM is NOT an excuse for lazy writing, for not doing the requisite analysis. The wrong stock can hand you a stunning loss even if written 20% or more ITM.  With discipline and proper trade selection, it is not necessary to write ITM to make consistent returns. It is not a bad place for newer traders to start, however, and look for larger returns as experience accumulates.

Another point seldom discussed in the context of ITM call writing is the greater ease of trade management. The higher level of downside protection with deeply ITM calls simply usually allows the trader more time for reflection and action if the stock pulls back. For an illustration of this point, suppose two traders were looking at hypothetical stock BUMM, which is at $20:

Trader Vic writes the 20 Call for $1.00 (5% potential return, $19.00 breakeven);

Trader Ric writes the 17.5 Call for $3.15 (3.25% potential return, $16.85 breakeven)

Neither play is necessarily better at the time of trade entry. Ric is trading more downside protection for a much lower return. Suppose the stock pulls back to $18.50. The stock is well below Vic's $19 breakeven, so he's sweating a bit. He had better be looking at a potential roll down to the 17.5 Call, if doing so would improve his position, but the last chance for a helpful roll may have passed (Vic should have been looking at a possible roll down before the stock ever hit his breakeven. If the stock continues to drop, Vic has to decide whether to ride out the pullback or take the loss. But the stock is well above Ric's breakeven point - he'll watch the stock a little more closely now and if the stock drops much more, will begin to look at a possible roll down to the 15 Call. As this example turned out, it was clearly better to have written the ITM 17.5 Call, but there is no way to be sure of that on trade entry.

Safer? I would say that writing ITM is more conservative than ATM or OTM writing, but not necessarily safer. Deeply ITM calls also almost always present a lower return than ATM or OTM calls; these days substantially less. In fact, as I write this, it is difficult to find a deeply ITM call that is paying more than 5% with 30 days left until expiration, and even a 5% return can be hard to find at the 30-day mark. The tradeoff for the large downside protection is a much lower return. But I have to emphasize this: writing ITM is NOT an excuse for lazy writing, for not doing the requisite analysis. The wrong stock can hand you a stunning loss even if written 20% or more ITM.  With discipline and proper trade selection, it is not necessary to write ITM to make consistent returns. It is not a bad place for newer traders to start, however, and look for larger returns as experience accumulates.

In my view, the important thing is to trade in accordance with your personality. For example, some people like to trade very actively: they watch their trades all the time and delight in looking for trades and modifying trades - closing them early, rolling the calls and such. (It helps in this trading style if you are close to a computer during the day and are able to watch trades all the time and react quickly to moves.) A less active trader might not be in a position, or might not care, to watch the trades constantly and may just want to run the trade, collect the premium and look for a new trade when called out. ITM calls make it easier to check on trades only once a day, and some writers don't even check them daily. Sure, any stock can pull back hard without real warning, but when stable, large-cap stocks are being written, there is less reason for concern. And there are call writers who do very well writing ITM, occasionally closing the trade early when it appears advantageous. They may not make the highest returns of all call writers, but many of them argue that the peace of mind is well worth it - they generally will have more reaction room than ATM and OTM writers and are willing to trade that for lower returns.

I believe, based on experience, that ATM and especially OTM covered call trades have to be watched a little more closely than those ITM. It is not a right or wrong issue, but a decision to be made on mature reflection. Do what is right for you.

Question:   I've heard that the safest stocks on which to write covered calls are the ETFs, such as the Diamonds and QQQQ. Would you agree or disagree with that statement?

Answer:  The two ETFs you mention are Exchange Traded Funds (ETFs), which are investment structures that pool the assets of their investors and invest the funds in stock market or similar indices. There are also ETFs that are geared to other markets and designed to produce current income or capital appreciation, such as municipal bond funds. But when most people refer to ETFs, they mean the Index ETFs. There are many of them, but the most well known are the Spiders (SPDR 500; Symbol SPY; comprised of the S&P 500 index stocks), the Cubes (Nasdaq 100 Trust Series I; Symbol QQQQ; comprised of the Nasdaq 100 stocks), and the Diamonds (Diamonds Trust Series I; Symbol DIA; comprised of Dow Jones Industrial Average stocks).

ETFs are also known as tracking stocks, since the ETF shares that are publicly traded closely track the fortunes of the underlying index. But ETF stocks can be volatile, especially those that track smaller indices. In fact, the smaller the index, the more potential it has to be volatile, due to the modern phenomenon of sector rotation, the tendency of an industry group or even a sector to sell off when one of its leading bellwether stocks is hit. If the industry or sector underlying an ETF goes into rotation, it will feel pretty darn volatile. Although the major indices have not been particularly volatile in the last year or so, when they move, they can really move - just like any other stock. Moreover, we are seeing in the last year an amplified tendency for the markets to split, as when the S&P 500 is up and the Nasdaq is down. In a market that tends to split, which ETF should you be in at any given time, exactly?

Finally, the covered call returns offered by ETFs are abysmal. Actually, at any time you can pretty much figure that returns on ETF covered calls will be about half of the return offered by trades on CallWriter's deep in the money lists, which are themselves some of our lower returns. This raises the question of whether it is really safer to write ETF stocks for returns that are well under half the returns one could expect from writing at-the-money calls on corporate stocks. I don't think so, but we offer ETF lists for CallWriter members, since some of our members prefer them. I believe that with proper trade selection, it is possible to get consistent returns that are much higher than are obtainable from writing ETFs.

For more information about them, visit ETFConnect, a site devoted solely to the world of ETFs.

Good luck and good trading!