Q and A. Writing Deep In The Money Covered Calls

Mark,

I just stumbled across MDWOptions.com and must compliment you for a very easy-to-read site that is both "usable" and "readable" in terms of content and style. Thanks...Your articles and comments, as with your blog, are a hidden gem in the retail investing education world, and I'm glad to have found your stuff over the weekend.

[I could not resist including the above comments; I certainly appreciate receiving them]

I've not found anyone who can give me a decent answer about DITM covered call writing.

Let's say investor X has a long-term stock position and has made some nice profits over the years by writing covered calls on it, and collecting its quarterly dividend.  However, his investment thesis has changed, and the stock is trading at $6.50, down from his initial cost basis of $9.  Looking at the call chains, the investor looks for a covered call to sell, perhaps allowing him to recover his unrealized capital loss on the position.

My belief is that history is irrelevant.  Whether the position has been a winner or a loser should have no bearing on your decision concerning what to do now.

According to his broker, a front-month very DITM call (all intrinsic value, delta = 100) would give a $4 credit and the b/e on the position of ~ $6.50.  As investor X sees it, the premium received would more than offset the unrealized capital loss on the position, and come expiration, the underlying would be called away at $6.50.  Thus, the investor has used options to "dump" his shares and recoup his paper loss. Sure, the option sold is already in the money, but the plan would be to allow the stock to be called away anyway.

Is there something I am missing from this hypothetical strategy I describe?

Rick

Yes.  The underlying would be sold at $2.50 - the strike price, not $6.50.  Your net selling price is $650 because you get $400 now and $250 when assigned an exercise notice.

When you sell a covered call (CC) the profit potential in the trade is represented by the time premium in the option.  Writing options with zero time premium is a very bad idea.  You have nothing to gain, pay commissions to the broker, and incur risk.  If your plan is to accept $6.50 for the shares, better to just sell them now, rather than wait for expiration to arrive.

If you want to try to earn some money and are willing to take the chance of holding this stock, consider writing a call with a strike of 5 - providing it has enough time premium to make it worth your while.  If this call can be sold @ $1.55, that's only $5 of time premium - before commissions - in your pocket, and is not worth your time. 

That time premium is your reward for taking the risk of holding the position through expiration.  If the stock drops below $5 per share by then, you will lose more money.  Thus, this is not a free play.  There is some risk.  That's why you must have an acceptable (to you) reward for taking that risk.

When you sell the DITM at parity (zero time premium), you gain nothing for the risk you take.

If you make the trade recommended by your broker, You would pay an extra commission (one to sell option plus one for assignment; vs one commissions to sell stock now).  Thus, holding gains nothing, incurs extra costs, and involves a minimal risk of a stock price collapse.

Here's my main comment: The broker had been no help and does not appear to understand how options work.  If he/she is paying a full service broker's high commissions, investor X deserves much better advice than this person is providing.

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