This post will examine the benefits and drawbacks of the covered call strategy, which involves buying stock while selling call options. We’ll also take a look at a case study that includes ATM, OTM, and ITM cover calls combined. Covered call methods hope to generate income through option premiums.
Benefits of the Covered Call Strategy:
- Reduce the cost basis of the stock you purchased.
- It protects against the downside.
- The downside protection provided by an ITM covered call is larger, but the ROI is smaller.
- OTM covered calls give a higher ROI but give less downside protection if the price falls.
- Easy to care for
- If the initial covered call is broken, it is rather simple to implement a repair strategy.
Downside of the Covered Call Strategy
- Because the covered call premium should cap the maximum profit, the ROI is limited.
- If the stock falls and you want to sell the stock to avoid further losses, you must first buy back the call options before selling the stock. That is, you must liquidate your entire position.
Benefits of the ITM (In the Money) Covered Calls
- Capture at least 15% of the downside risk.
- It provides the highest premium and the most downside protection in the event of a stock decline or a declining market.
- Because the calls are ITM, they are more likely to be assigned. You may take your profit and move on.
- Very little maintenance
Downside of the ITM Covered Calls
- When volatility is low in an uptrend market, profit margins are reduced.
- The ROI is lower than other covered call strategies because the option premium received is mostly intrinsic value. Your profit is the premium’s time value. For example, BP stock is $27.98. You’re uncertain about the oil market in the coming months. You decided to sell an In-the-Money $27 call for $1.39. Your net profit is $0.41.
Cost of the stock $27.98 - Option Premium Received $1.39 Adjusted cost basis $26.59
Agreed to Sell Stock at $27.00 - Adjusted cost basis $26.59 Profit $ 0.41
Benefits of the OTM or ATM Covered Calls
- Profitability increased when the covered call expired worthless, and the stock was trading above the purchase price at the time of expiration.
- It works effectively in a market that is either neutral or rising.
Downside of the OTM or ATM Covered Calls
- It is best to avoid using the covered call strategy during earnings announcements if the stock drops abruptly due to weak earnings or future guidance.
- The OTM or ATM covered calls provide less downside protection in comparison to the ITM.
Use Case Study: The ATM, OTM, and ITM Covered Call Strategies All Work Together
In this case study, we purchased The Chemours Company (CC) stock on June 23, 2021, at a price of $34.34 per share. We also sold the July $36 monthly call at $0.63 per share at the same time. We rolled out and down the covered calls as the stock fell. On October 11, the stock was trading between $31 and $32 per share. We made the decision to roll out and up the covered calls. As a result, the cost basis of the stock has increased from $29.16 to $31.12, as you can see in the table below. The cost base is now $30.43 at the time of writing.
By December 17, 2021, if we do nothing and the stock price rises above $32 a share, we will have made a profit of $1.57, or 5 percent, in just six months.
In comparison to the buy-and-hold stock strategy, if the stock is trading at $32 per share, we will still incur a loss of $2.34 per share, or 7 percent.