The Tycoon Report

A little known Covered Call Strategy

I love options. To me, they are one of the greatest investment and trading tools out there.

However, when most folks try to use options, they get burnt. This applies even more to wildly gyrating markets such as the ones we currently have.

Does that mean options are risky and should be avoided? Not at all.

When I talk to people who use options, most use them as a tool for leveraged and/or directional trading. In other words, if you want to go long a position, you buy a call; if you want to go short, you use puts.

In this familiar case, you can either choose an option that is ITM (in the money), OTM (out of the money) or ATM (at the money).

(The Tycoon Report offers some great articles on this approach, by the way. If you want to learn

more about these strategies check out what Chris and Teeka wrote).

There is, however, another very popular approach: Writing Calls/Covered Calls.

When you read about covered calls in articles or most option books, you often find the same approach:

If you are moderately bullish on a stock, but do not expect it to rise beyond a certain level or are fine with being called away, you sell a call which is close to or ATM.

The idea behind it is simple: You want to reduce your initial cost basis on the stock position.

This strategy tends to work well in overbought situations.

However, What most people do not realize is that there is another strategy for writing covered calls, so called deep in the money calls.

Picture the following situation (NOT A TRADING EXAMPLE, just for illustration purposes!):

AMR Corp (US:AMR) is trading at $8.64, the Aug 08, $7.5 call option close to expiry (about 2 weeks way at the day of writing this article) has a bid price of $1.65

Now, let us say we purchase 1000 stocks in AMR, then sell 10 calls against our existing position (remember: one option stands for 100 stocks).

The result in our account:

-$8640

$1650

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-$6990

We have now reduced our cost basis to $6.99 per stock; in other words: we have established a downside cushion of 19.10%

Sounds great?

Well, there is a popular misconception about this strategy: Our option strike price is at $7.5, so we have to look at the situation differently:

In the example above, we went short (which means we sold) 10 calls at $1.65.

However, when the stock is at $8.64 and the strike price of our call at $7.5, the party we sold our calls to will be eligible to buy the stock from us at a $7.5 price level.

This is why the biggest part of the money we received for selling the calls has to be subtracted from our actual profit:

$8.64-$7.5= $1.14 (x100 = $114)

Hence, we have to subtract $114 from $165 to calculate the actual premium we receive and get to keep once the contract expires.

What we receive is $51 per contract, in our exaple $510.

Essentially, we have put $6990 to work, so $510 is about 7.3% we can make on this one within two weeks. In addition, we have a downside cushion in the stock of about 19.10% in this example.

In other words: What you want to do when employing this strategy is collecting premiums as high as possible while successfully managing your downside risk (and having a good cushion in place).

In our case, the stock could trade down to $6.99 and we would still be making money due to our strongly reduced cost basis. Only if it trades below $6.99 we would start losing money. If the stock goes up, we are not affected at all and still get to collect the premium.

Some folks might argue that 7.3% is a "boring return", however, the real potential of this strategy becomes obvious if you factor in compound interest (remember that you can keep using this strategy consistently without any problems).

Let us be conservative and say you make 4.5% each month on your capital by using deep in the money covered calls. Factoring in compound interest, you end up with a whooping 69% return on your total capital at the end of the year! If you really max this strategy out, can make even more than 100% and more each year, while having nice downside cushions and not really caring about where the stock is going, given it stays within your "save zone".

Granted, if it was that easy, everybody would do it. Nevertheless, you can practice this strategy by paper trading and once you become good enough at it, you can give it a shot.

It has been working greatly for me and I am sure it could also be a valuable additional tool in any arsenal of trading methods, especially during very risky markets such as the ones we currently have.

With this article, I just wanted to quickly introduce deep in the money covered writing to most of the readers on this website. If you would like to know more details or more about the strategy itself, feel free to leave some feedback or to rate this article.

Any comments are greatly appreciated.

Alexander P. Hahn

Disclaimer:

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Speculating in the financial markets is risky and should never be done with capital you cannot afford to lose. Nothing in this article should be seen as a recommendation to buy, sell or hold any securities nor invididual investment advice.

The only intention of this text is to inform about a little known covered call strategy. The editor of this article does not accept any liability

for damages or losses that result from using or putting this strategy into work. There is no trading strategy that completely eliminates risk in the market.

A downside cushion in deep in the money covered calls does not imply that solid research in any position you plan to enter is not a must. Even a big downside cushion, while reducing risk, is no guarantee for a profitable trade result.