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Trading Deep-In-The-Money Covered Calls
The Smart Profits Report: Issue #155
Wednesday, October 27, 2004
Trading Deep-In-The-Money Covered Calls: Dividend Paying Stocks That Can Boost Income
by Karim Rahemtulla
Investment Director, Mt. Vernon Research
One of my most satisfying trades is when I can pull a fast one on the market.
My favorite options trading strategy is trading deep-in-the-money covered calls. In fact, I like it so much I even have a trading service dedicated to it.
Ordinarily, when I trade a covered call, I buy the stock and sell a call against it. This is usually done deep-in-the-money so that I can manage my downside in case the market or the stock heads south.
These days that happens more often than not. Still, I manage to rack up wins more than 70% of the time.
But every once in a while I intentionally take the market for a ride by using my strategy on high dividend paying stocks.
Today, I am going to let you in on a little secret that very few people know about - and I’ll show you how I recently used it to increase my income returns by 143%. Let me explain…
Boosting Income From 8% to 20% - With One Easy Trade
Earlier this year, I knew that General Electric was a good company, but I was not comfortable owning it at current prices. So after doing some research, I found that GE had plenty of attractive deep-in-the-money options to choose from. (The prices I’m using here are recent, but not current… and keep in mind that this is not a recommendation of GE.)
At the time I made the actual trade, GE stock was at $31. I bought GE at $31 and I sold the $25 GE calls against the position. The calls expired in six months and the premium was $7. So my cost for GE was $24 and my upside limited to $25 - not so attractive, right?
This trade was set to return 4.1% (about 8.2% annualized) in six months - no big deal.
Here’s how I made it a big deal… and increased that annualized return by about 143%…
Covered Calls Work With Dividend Paying Stocks
Remember, you can only play this trick on a dividend paying stock.
GE pays a healthy dividend, about 20 cents a quarter. So my possible return, if I collected two dividend payouts as well as my premium, was 6% in six months… getting better, but still not great.
But this is great: I knew that if GE continued to trade at $30 or above with less than three months to expiration, they would call the shares away early so that I couldn’t collect that last dividend. The market makers knew that the chances of GE dropping 20% or more in three months were slim. They were playing probabilities.
So, instead of letting me collect the dividend, they collected the dividend. And since three months had passed, the premium on the $25 option had fallen substantially as well.
At the end of the day, I made 5% in three months, or 20% annualized on my money - because I didn’t lose the last three months of time value on the option, and I was out of the trade in half the time.
Now 20% is not chump change, especially when the S&P 500 is in the red.
You should consider this technique with any new deep-in-the-money covered calls you do on dividend paying stocks - you could increase your returns by triple digits.
Good Trading,
Karim Rahemtulla
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Today’s Smart Profits Cribsheet
- Option terms have you stumped? Check out our Smart Profits Glossary for definitions of words like, “deep-in-the-money” or “beta.”
- Also, check out Smart Profits #180, Deep-In-The-Money Covered Calls - How to Beat Stocks with Less Risk, for more information on this type of option strategy.
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