OPTIONS
The In-The-Money Covered-Call Portfolio
Downside Protection With Double-Digit Returns
This strategy has potential for double-digit returns with a large built-in hedge.
Current market conditions have set up a unique opportunity to build a conservative portfolio that will profit even if the market falls by a certain percent, stays flat, or eventually rises over the remainder of the year. It goes without saying we have witnessed the most violent and dramatic market moves of the last 75 years of late. After falling a whopping 38.5% in 2008, the Standard & Poor’s 500 is already down another 21% in the first eight weeks of 2009. How does a traditional investor defend himself against this kind of market volatility and still have a chance of making money?
The Premise
What if you could build a diversified portfolio of quality stocks or exchange traded funds (Etfs) with a large built-in hedge of anywhere from 20% to 40% below entry prices and still pull off double-digit gains at the end of the year, even if the markets go nowhere? You can. Welcome to the in-the-money covered-call portfolio!
What makes this strategy particularly attractive right now is that we have two favorable conditions present — depressed stock prices (subjectively, prices could fall further, but I am about to show you that’s okay) and high premiums for options (elevated implied volatility priced into options). One of the other desirable attributes of this strategy is that it is relatively low maintenance. It is perfect for the busy trader or investor who doesn’t have time to check the markets all the time — and it keeps transaction costs down.
The Mechanics
An in-the-money covered call is a simple two-part strategy. Part 1 is the purchase of your chosen underlying instrument (stock or Etf). I will address the criteria for selection later. Part 2 involves selling a long dated call option below the purchase price of the stock/Etf. How far below you sell a call is subject to your analysis and desired return. The further below your stock purchase price, the greater the hedge (protection) but lower the overall return. The risk/reward tradeoff is at play here.
Figure 1: which call option do you sell? If you sell the $25 strike against the stock, it will give you the greatest return but less downside protection. The $20 strike price will give you the greatest hedge, but also a lower return. Say you sell the $22.50 strike against the stock. You can go into the market and collect $12.20 in premium for the January 2010 $22.50 call option.
But why would an investor commit himself to sell a stock below his purchase price? The answer is quite simple: premium collected. When we sell an in-the-money call option, there are two components of the total premium collected: intrinsic value (the difference between the strike price of the call you sell and the current stock price) and extrinsic value (the time value factored into the option premium). If the stock begins to fall toward the sold call’s strike price the stock will lose money, but the option intrinsic value will accumulate profits because we are short the option. Because of the canceling effect between the stock price and the intrinsic value of the option premium, your profit will come from the extrinsic (or time value of the option), which will erode as time moves forward. We are acting very much like an insurance company that has sold a policy.