In the Money Covered Calls as a Conservative Income Generator

The last couple of weeks’ articles, which you can read here and here, dealt with the time value in a call option and its ups and downs. We’ll polish off this series with a description of a strategy that can be used to generate a moderate amount of income with a relatively small amount of risk.

This is the in-the-money covered call, where we sell call options whose strike prices are lower than the present price of a stock that we own (or buy for the purpose). We fully expect to have the stock taken away from us in this strategy, and if that happens we make a pretty nice profit, which is equal to the time value in the call options. If the stock drops and does not get taken away from us, then we will still have reduced our net cost of that stock considerably. Here’s how it works.

Let’s say we believe that the price of oil, which has dropped by almost 50% in the last six months, will not fall too much farther.

At a present price of $20.39, USO, the exchange-traded fund that tracks the price of crude oil, equates to a crude oil price of $53.82 per barrel. This is a drop of 51% from the June 2014 high of $107.68 per barrel, and is the lowest price since 2009.

For a little more perspective, the inflation-adjusted price of crude oil in January 2009, after an 81% crash, was $43.58. If the current slide continued to that point, that could represent a further drop of $53.82 – $43.58 = $10.24 per barrel, which is another 19%. For USO, that would mean a further drop of $3.73, to around $16.66.

Let’s say we believe that that is as far as it will probably go, and that even that is unlikely. (Not a recommendation, just saying). And while we’re sayin’, let’s say that we believe that the current oil price wars will be resolved in the next six months, and that oil prices will then eventually return to more normal levels above $75 per barrel, which would be above about $28 for USO.

We also note that at 50%, the implied volatility on USO options is very high, meaning the time value component of these options is extremely expensive. It is at levels not seen since the shocks of the summers of 2010 and 2011. Those levels, in turn, were only exceeded in the massive stock-bond-gold-commodities-real estate meltdown of 2008-9, when implied volatility on oil exceeded 90%. So we know that a further massive crash and expansion of option premiums is not outside the realm of possibility, but we believe (let’s say) that the worst damage has been done, and that options are ripe for selling.

With this outlook, we could buy 100 shares of USO today at 20.39. The July 2015 call options at the 19 strike are selling at about $3.43. This includes $1.39 of intrinsic value ($20.39 – 19.00), and $2.04 worth of time value ($3.43 – $1.39). Our net outlay for the 100 shares would be $2039 – $343 = $1696, or $16.96 per share. Here are our possible outcomes:

Worst case – oil drops further and USO is below $19 at the July expiration. In that case, the stock is not called away from us. We now own it at a net cost of $16.96. Looking at that possibility as of today, we don’t think that this “worst-case” scenario is all that bad. If a drop back to 2009 lows would mean a USO price around $16.66, and we would own it at just a few pennies above that, then that is an outcome that we can live with. We would be happy to hold on to USO at a net cost of $16.96, and wait for its inevitable recovery.

More likely scenario (we believe) – USO is above $19 in six months. The shares are called away, and we are paid $19 at that time. Our profit is $1900 – $1696, or $204. (Note that this amount, $2.04 per share, is the amount of time value that was in the $19 options when we sold them. In an in-the-money covered call, this time value is always our maximum profit). This is on an investment of $1696, over a period of 7 months, or a net annualized return of about 20%.

Bearing in mind the lessons from the previous two weeks’ articles, we also know that it is possible that we could make almost all of that $204 maximum return in less than seven months, which would make our annualized return higher. This would happen if in the meanwhile the price of USO shoots up so far that our $19 short calls are deeply in the money.

For example, let’s imagine that three months from now USO recovers back to $25 (where it was as recently as December 5). Meanwhile, implied volatility has dropped from its crash-mode level of 50% to a still-high 30%. At that point our $19 options would have $6 per share of intrinsic value. But they would have almost no time value – maybe $.20 per share, so that they would then be selling for about $6.20.

At that point we could “assign ourselves,” as described in a recent article. We would do this by buying back the calls at $6.20, and selling the USO stock at $25, for net proceeds of $25.00 – $6.20 = $18.80. This is $.20 less than the $19 strike price, which is the amount that we would receive four months later if we left the position alone. By paying for that $.20 worth of time value, we have reduced our net profit by $.20 compared to its $2.04 maximum, and our profit is now $1.84 per share. We can verify this by taking our current net proceeds of $ 18.80 and subtracting our original net cost of $16.96. The difference is $1.84.

However, we have made that $1.84 on $16.96 not in seven months, but in three months. As an annualized rate of return, instead of the 20% max that we had planned on, our annualized return is now 43%. We now are liquid again and can invest this money in another opportunity where we would hope to do much better than the extra $20 total that we could have collected by waiting another four months.

In summary, our in-the-money covered call position allows us to take in a substantial amount of cash now for overpriced calls. It has a high probability of being assigned, in which case we make a known amount of money if held until expiration. If the stock moves our way in a substantial way before expiration, there is a possibility of making almost all of that money in a shorter period of time, and even if the call is not assigned it will reduce the net cost of our stock position very substantially. For many people, this is a very attractive strategy.

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Source:: In the Money Covered Calls as a Conservative Income Generator