Covered calls may seem boring to more sophisticated option traders, but an innovative approach to this method might warrant its inclusion in any strategic arsenal. The covered call strategy that is used by most investors is to own the stock and then sell out-of-the-money (OTM) calls against those shares, with 1 call option contract for every 100 shares of stock owned. This is a “covered” strategy, with no required margin on the short calls, although the stock can be “called away” in the event that the options are exercised.
Traders and investors use this strategy on bullish stocks, and in some cases will “roll” the options if the stock rises too far…closing out the short options for a loss and then selling further OTM calls, perhaps in a farther month. But we would like you to consider a more innovative way to implement the covered call strategy. Selling deep in-the-money (ITM) calls when they are pumped with time premium.
The Deep ITM approach
This approach involves finding situations when deep ITM calls options have very high implied volatilities (IV), and hence excessive time premium. We then simultaneously buy the stock and sell these lucrative ITM calls. How do you make money on this trade? When the options expire ITM they are assigned and the stock is called away. Since you are required to sell the stock at the strike price of the calls, the time premium you collected represents your return.
Now here’s the catch. Fat ITM time premium levels tend to occur after a sharp decline in a stock’s price. When this happens, the implied volatility levels quickly increase and a volatility skew takes shape that causes the ITM calls have higher IV levels than the OTM calls. The OTM puts will also have a higher IV level than the at-the-money puts. If your other analysis concludes that the sell-off is finished and the stock has bottomed, then it makes sense to capitalize on those pumped up ITM call premiums.
Let’s look at an example. On July 25, 2006 United Parcel Service (Symbol: UPS) experienced a 10% drop at the open due to the release of a poor earnings report. By July 28 it was down a total of 14% and the price seemed to have stabilized around $68.45 and a trader might have concluded that the sell-off was finished. You can see the price history for UPS in the chart below. Notice how the price decline was accompanied by a sharp increase in volatility levels.
On July 28, the August 65 calls had about $0.65 in time premium with just 23 days remaining in their life. After buying the stock on margin, this premium represents a yield of nearly 3% or over a 50% annualized yield. Not bad for a trade with a theoretical probability of profit of 84%. The figure below shows the risk graph of this trade.
Finding these Trades
How would you find trades like these? One way would be to simply monitor a “Sharpest Declines” list on one of many free financial websites, and then follow those to see which ones mat have bottomed. An easier way and more direct way to find the actual options you might consider selling would be to use our OpScan service to scan the market for likely candidates.
The OpScan service can quickly scan all optionable stocks and find those that have expensive ITM near-month call premiums with a lot of time premium. You can then take that list and analyze the stocks to find those you feel are likely to stay within a price range or move upward. Below is a specific formula that could be used with OpScan.
Pick Line: ITMM(20), CALLS, DAYS<45, LASTU>10
The Pick Line establishes the population of items to be sorted. Here, ITMM(20) means that we only consider options that are more than 20% in-the-money. CALLS tells OpScan we want only call options reported, and DAYS<45 keeps the group to options that expire in 45 days or less. The final item – LASTU>10 – removes all options whose underlying stock price is less than $10 from the report.
Now that we have our group of possible trade candidates, we have to decide in what order the results should be presented. Remember, the time premium you that you keep represents your return, or yield. And we want the call options that give us the highest yield to be at the top of the report. The OpScan database does include a parameter for time premium (TPREM) that could potentially be used to sort the results, but it is based on the market price for each option rather than the Bid or Asked price. Our situation requires that we pay closer attention to the Bid price, since deep ITM options tend to have higher bid/ask spreads than other options. So we use as our sort value:
Sort Line: ((BID-(LASTU-STRIKE))/LASTU)*2
The first part of the formula – BID-(LASTU-STRIKE) – calculates the option’s time premium based on the Bid price being quoted. We then divide this by the stock’s last price, LASTU, to get the yield this option trade would have on a non-margin basis. The final adjustment, multiplying the resulting yield by 2, is to take show the trade if we took advantage of 50% margin when purchasing the stock.
All that’s left for you to do is determine which option you think have a high probability of expiring in-the-money, and making sure you think the stock has bottomed out. But without doing any further research, if we were to sell those October 20 calls on New River Pharmas (Symbol: NRPH) and buy 1,000 shares on margin, it would cost $7,655. The risk/reward for this trade is illustrated in the Graphic Analysis below:
As long as New River Pharmas – which is currently trading at $25.25 – remains above $20 in the next 18 days we should see a profit of $2,340. That’s a 31% return in just 18 days! That would definitely be one add to our list of possible trades for further research.
Selling deep in-the-money call options represents an innovative approach to obtaining high probability yields. The primary risk in this strategy is that the underlying stock may move further downward. That means doing the research to decide which stocks are most likely trade above the strike price you are considering by the expiration date. This is not a get rich quick strategy, but the returns can be considerable for those with a penchant for this type of stock analysis.