Options Trading Made Easy: In-the-Money Covered Call

There are a number of alternatives to the traditional covered call strategy, each of which possesses its own distinct advantages and disadvantages.
The diagonal bull call spread, for example, is a form of covered call that obviates the need to buy the underlying shares, thereby saving the trader handsomely on his initial outlay of funds.
In this article we want to examine one more strategy that permits the trader to fine tune his covered call initiative.

In-the-Money Covered Calls

It might seem counterintuitive, but there are good reasons for employing an in-the-money covered call. Before we get to them, however, let’s make a quick review of the traditional covered call.
Remember: The normal drill is to buy 100 shares of stock and sell a call at a slightly higher price than where the stock is currently trading. That affords the trader two benefits: first, he earns premium from the sale of the call; and second, he creates the potential to earn a capital gain should the stock rise to the strike price and be called away.
In-the-money covered calls dispense with the latter benefit, opting for more premium up front, with the expectation that the stock will not rise toward expiry. Rather, the writer of the in-the-money covered call is banking on a sideways – or even slightly lower – trajectory for the underlying shares.
Let’s take a look at a real-life example to see how it works.
Below is a chart of the S&P 500 from early in 2015. The red circle is the date an in-the-money covered call was initiated, and the blue circle indicates when it expired.

The trade was initiated at the end of February by purchasing 100 shares of the SPDR S&P 500 ETF (NYSEArca: SPY) for $21,100 ($211 x 100) and selling the in-the money April 210 call for $7.00.
The net debit for the trade is $20,400 ([$211 – $7] x 100) and because the strike price is lower than the stock, there is no benefit to be had from the stock rising. The trader’s gains are limited to the premiums he obtains at the outset of the trade – in this case $700.
So why do it?
A look at the break-even points for the trade will help us to understand better.

• Should the stock sink below $204, the trader will be in a net loss position. That price represents his initial outlay for the shares ($21,100), less the premium he took in ($700).
• On the upside, should the stock rise above $217 he’ll also begin losing money. The short call obligates him to sell his shares at $210 – for a return of $21,000 – and the call fetches him an additional $700, for a total take of $21,700. Above the $217 per share mark, he loses.

The sweet spot for the trade, therefore, falls between those two levels – $204 and $217.  Anywhere in that range and the trader will profit.
And what happened?
Indeed, that’s what occurred. The stock closed at $210.80 at expiry, the shares were called away for $210 each, resulting in a $20 loss for the shares, but a $700 take from the options. The net gain was $680.
The in-the-money covered call is thus perfect for a sideways moving market.

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