ITM Covered Call

Unlocking the Potential of Selling In-the-Money Covered Calls: A Strategic Approach

Covered calls are a popular strategy for investors looking to generate additional income from their stock holdings. Within this category, selling in-the-money covered calls is a slightly more conservative variation that can help protect against downside risk while still generating returns. Here’s a deep dive into how this strategy works, its benefits, risks, and when it might be the right choice for your portfolio.

What Is an In-the-Money Covered Call?

A covered call involves owning a stock and selling a call option on that stock. When the strike price of the call is below the current market price, it is considered “in-the-money” (ITM). For example:

• Stock Price: $50
• Call Strike Price: $45 (ITM because it is below $50)

When selling an ITM covered call, the option premium you receive is higher because the call has intrinsic value in addition to time value. However, if the stock price stays above the strike price at expiration, your shares will likely be called away.

Why Use the In-the-Money Covered Call Strategy?

Selling ITM covered calls is typically used by investors seeking:

1. Income Generation with Downside Protection
   The option premium includes intrinsic value, providing a buffer against potential stock price declines.
2. Moderate Risk Reduction
   ITM calls reduce your exposure to downward price movements in the stock, as the premium offsets losses up to a certain point.
3. Profit Capture on Stocks Near Target Prices
   If you hold a stock that has appreciated and reached your price target, selling ITM calls allows you to lock in gains and earn additional premium income.
4. Exit Strategy with Income
   This approach is ideal for investors ready to sell a stock but want to squeeze a bit more return from the position before letting it go.

How It Works: A Step-by-Step Example

1. Own Stock Shares
   Assume you own 100 shares of XYZ, currently trading at $50.
2. Sell an ITM Call
   You sell a call option with a strike price of $45 for a premium of $6 per share.
   • Intrinsic value: $5 ($50 market price – $45 strike price)
   • Time value: $1
3. Possible Scenarios at Expiration
   • Scenario 1: Stock Price Above $45 (Called Away)
     If XYZ closes at $48, your shares will be sold at $45 (strike price). However, you keep the $6 premium, making your total return:
     • $45 from the stock sale + $6 premium = $51 per share.
       This represents a $1 profit over the current price, even though the stock was called away.
   • Scenario 2: Stock Price Below $45 (Option Expires)
     If XYZ closes at $43, the option expires worthless. You keep your shares and the $6 premium, reducing your effective cost basis:
     • $50 (original price) – $6 (premium) = $44 cost basis.

Key Benefits

1. Enhanced Income
   The intrinsic value of an ITM call provides higher premium income than an at-the-money (ATM) or out-of-the-money (OTM) call.
2. Downside Cushion
   By collecting a higher premium, you lower your breakeven price on the stock. This helps protect against moderate declines in the stock price.
3. Predictable Exit Point
   Selling ITM calls is a disciplined way to exit a position near your target price, making it useful for managing portfolio turnover.

Risks and Considerations

1. Limited Upside Potential
   Your profit is capped at the strike price plus the premium received. If the stock rallies significantly, you miss out on additional gains.
2. Assignment Risk
   ITM calls are more likely to be exercised before expiration, particularly if the stock pays a dividend or is deep ITM.
3. Downside Risk Beyond Premium
   While the premium provides a buffer, if the stock declines significantly, you still incur losses.
4. Tax Implications
   If your shares are called away, it triggers a taxable event, potentially resulting in capital gains taxes. Always consider the tax impact when executing this strategy.

When to Use This Strategy

• Stable to Slightly Bearish Outlook
  If you believe the stock may decline slightly or remain flat, ITM calls generate income while offering downside protection.
• Stocks at a Target Price
  Use ITM covered calls as an exit strategy for stocks that have appreciated to your goal price but aren’t expected to rally further.
• Portfolio Income Needs
  This strategy suits income-focused investors who prioritize consistent cash flow over capturing significant stock appreciation.

Best Practices

1. Choose Strike Prices Wisely
   Select strike prices close to your target exit price. A strike too deep ITM might limit returns excessively, while a shallow ITM strike offers less protection.
2. Monitor Volatility
   Higher implied volatility (IV) increases option premiums, enhancing income potential. Consider selling ITM calls in high-IV environments.
3. Know Your Stock’s Fundamentals
   Ensure the stock aligns with your strategy. Selling ITM calls on highly volatile or speculative stocks can lead to unexpected losses.
4. Use with Dividend Stocks
   Selling ITM calls on dividend-paying stocks can further enhance returns, but be cautious of early assignment around the ex-dividend date.

Conclusion

Selling in-the-money covered calls is a versatile strategy for investors looking to balance income generation with risk mitigation. While it limits upside potential, the higher premium and downside cushion make it an excellent choice for stocks nearing a sell point or in markets with moderate bearish trends.

By understanding the mechanics, risks, and best use cases for this approach, you can confidently implement ITM covered calls to optimize returns and protect your portfolio. Whether you’re an income-focused investor or seeking a structured exit strategy, this tactic provides a reliable path to consistent performance.