Overview
We’ll look at a case study that covers selling ATM covered calls as well as OTM and ITM covered calls. This post will also examine the benefits and drawbacks of the covered call strategy, which involves buying stock while selling call options.
Pros and Cons of Selling Covered Calls
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.
- When compared to OTM covered calls, ATM covered calls offer more downside protection; nevertheless, the return on investment is lower.
- 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.
Selling ATM (At the Money) Covered Calls Strategy
This strategy works quite well in a range-bound market. Your outlook on the market is neutral at the moment. The technique produces a steady stream of income. This strategy should only be applied to stocks that you would be comfortable selling. You run the risk of missing out on significant gains in the stock price. While the monthly profits from option premiums may be larger, the stock’s upside potential is constrained by the close placement of the ATM (at the money) call strike price to the present stock price. However, this approach can result in a sizable profit. When there is nothing obvious that may cause a stock price to rise, this strategy can be useful.
Here we see that Apple stock is trading at $165.20 per share. If we assume that Apple will remain in a tight trading range for the next month, we may sell the $165 at the money (ATM) call expiring in 34 days for $5.63. As long as the price of the stock remains above $159.57 up to the option’s expiration, the trade will be profitable. In addition, we get to keep the shares and sell more calls against them if the price of the underlying stock remains below $165 until expiration.
The Pros and Cons of Selling ATM Covered Calls or OTM Covered Calls
Benefits of Selling ATM Covered Calls or OTM 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 Selling ATM Covered Calls or OTM 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.
The Pros and Cons of Selling ITM Covered Calls
Benefits of the ITM (In the Money) Covered Calls
- Capture at least 10% 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
Example: Putting It All Together
Selling ATM Covered Calls, ITM Calls, and OTM Calls on Shares of Chemours Company
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.
