When to Sell Deep In The Money Covered Calls (SOXL Example)

Covered calls are a popular options trading strategy that we talk about often here at Dividend On Fire. It’s one of our core options strategies that we use to generate income from our existing stock holdings.

When executing a covered call, an investor sells a call option while simultaneously owning an equivalent number of shares of the underlying stock. One variation of this strategy is known as selling deep in the money covered calls, which offers unique advantages. In this article, we will explore the concept of deep in the money covered calls and discuss when it is optimal to implement this strategy.

when to sell deep in the money covered calls

Table of Contents

Understanding Deep In The Money Covered Calls

Definition and Explanation

The selling deep in the money calls strategy involves selling call options with a strike price well below the current stock price. This strategy offers both income and downside protection. By utilizing this technique, investors can benefit from the premium received while minimizing potential losses in case of a stock price decline.

This means that the call option has a high intrinsic value and is considered “in the money.”

By selling deep in the money covered calls, investors can capture a larger premium and potentially enjoy additional protection against downward price movements in the stock.

So to quickly re-cap: In-the-money covered calls involve an investor writing a call option against stock they already own (hence, it is “covered”).

The strike price of the call option, then, is lower than the current stock price (making it “in the money”).

For example, if a stock is trading at $55.50, any call option with a strike price of $55 or less would qualify as “in the money.

Benefits of Selling Deep In The Money Covered Calls

Selling deep in the money covered calls offers several advantages for investors:

  1. Increased Premium: Deep in the money call options have a higher intrinsic value, resulting in larger premiums for the investor. This provides an immediate cash flow and enhances the overall return on investment.
  2. Downside Protection: The intrinsic value of deep in the money covered calls acts as a cushion against potential stock price declines. If the stock price drops, the premium received from selling the call option can help offset losses.
  3. Lower Breakeven Point: Since the strike price of deep in the money covered calls is significantly below the stock’s market price, the breakeven point for the investor is lower. This provides a greater margin of safety and reduces the risk of losses.
what is deep in the money covered calls

When to Sell Deep In The Money Covered Calls

  1. You’re looking to sell the stock. By selling a deep in-the-money call option against it, you can earn some additional time premium for a stock you were already planning to sell.
  2. You’ve experienced a significant increase in the stock’s value and want to safeguard those recent gains. If you anticipate a modest decline in the stock’s price but prefer not to sell it, consider selling a deep in-the-money call option. This way, when the expected dip occurs, you can repurchase the option (thus shielding yourself from the decline). If, however, the stock doesn’t decline and you wish to retain it, you’ll need to repurchase the option (potentially at a loss) before it expires.
  3. You’re interested in executing a buy-write to achieve a higher yield compared to what you’d earn in cash. This is often the primary motivation for selling deep in-the-money calls. As long as the stock doesn’t end below the strike price at expiration, you can pre-determine your yield while you wait for it to be called away. However, exercise caution if earnings are scheduled to be released before option expiration, as this may lead to excessive volatility.
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In The Money Covered Call Example In SOXL

In this example, we are going to use a typical buy write strategy. 

Let’s say you like SOXL, which is the Direxion Daily Semiconductor Bull 3X Shares. SOXL is trading at $24.25 so any option with a strike price of $24 or below would be “in the money.”

You could buy 100 shares of SOXL at $24.25 (total out of pocket cost: $2425) and then write a November 17th $22 covered call option for $3.50/share ($350).

This means you receive $350 today in premium and your total out of pocket costs to place this trade are $2075 ($2425-$350).

Buy 100 shares of SOXL at $24.25/share

Costs: $2,425

Strategy: Sell 1x November in-the-money $22 covered call collect £3.50/share in premium

Receive: $350 premium

Net debit on this trade: $2,075 (Breakeven price SOXL trading at $20.75/share)

If, however, SOXL is trading over $22/share on November 17th (option expiration date) then 100 shares of SOXL will be called away and you will receive $22/share or $2,200.

At expiration, the call option is exercised and your 100 shares of SOXL are called away @ $22/share. You receive $2,200.

Net debit was: $2075

Profit on trade = $2200 – $2075 = $125

Return = 6% (125 / 2075)

Annualised Return: 72%

Let’s review the above example a little more.

If SOXL dropped from $24.25/share down to $22/share (at the covered call strike price) you would still make $125 in options premium. Winner!

This is because you still have $2.25 ($24.25-$22) of downside protection from the deep in the money call option that you sold.

Risks Associated with Selling Deep In The Money Covered Calls

So, what happens if SOXL was trading at below our net debit price?

Well, to put it simply, you would be nursing a loss.

Remember, the covered call only gives you some downside protection.

In this example it gave us a 9% protection (2.25 / 24.25).

So, SOXL would need to fall by more than 9% in a month before we would be sat on a loss.

What happens if SOXL rises by 9%?

Likewise, the most you would make is the $125.

This is the rub with the covered call strategy. You get some downside protection but at the expense of capping your potential upside.

Don’t forget though as options sellers we are never looking to swing for the fences. We leave the home run big money wins to the speculators.

If we can consistently make 6% return on our capital each month (which is a little on the high end I must admit) then we are in great shape long term.

Stock Selection For Selling Deep In The Money Calls

Careful consideration of the underlying stock is important when selling covered calls deep in the money. 

In the above example I used SOXL which is a low cost leveraged ETF. The reason for this is because it’s tradable for both large and small options selling account sizes. But, in general terms, I usually stick to the below criteria:

      1. Blue-Chip or High-Quality Stocks: Choosing stocks with a strong track record, stable earnings, and solid fundamentals. The Dividend Aristocats is a good place to start.

      1. Stocks with Moderate to Low Price Volatility: To minimise the risk of the stock thrashing around too much a beta of less than 1 is desirable.

    Selling deep in the money covered calls can be a valuable strategy for income generation and risk management for us options sellers.

    By understanding the optimal timing, market conditions, stock selection, and associated risks, you can effectively utilise this strategy to enhance your portfolio returns.

    If you are holding a particularly stock that has run up quite a bit and you feel perhaps the RSI reading is screaming overbought, you could look to deploy the in-the-money covered call strategy as a means of protection.

    As always, happy investing!

    Frequently Asked Questions (FAQs)

    In simple terms, for most investors, anything that’s over 10% in the money is considered “deep in the money”.

    While deep in the money covered calls can be used for most stocks, it is advisable to focus on blue-chip or high-quality stocks with moderate to low price volatility.

    If the stock price drops below the strike price of a deep in the money covered call, the investor retains the premium received from selling the call option, which helps offset potential losses.

    Here are a few tips for rolling deep in the money covered calls:

    1. Plan ahead. When selling covered calls, always have an exit strategy in mind if the stock price rises significantly. Don’t wait until the deep-in-the-money call option before thinking about how you’ll manage the position.
    2. Roll up and out. If the option is deep ITM with time remaining, consider rolling it to a higher strike price with a later expiration. This allows you to collect additional premiums while maintaining upside exposure in the stock. Just be wary of rolling too far out in time.

    I have been caught with my hand in the cookie jar a few times selling covered calls and finding myself deep in the money. In particular, I got caught out badly with Enphase (which at the time of this article I am still managing). I have been in a dog fight with $ENPH for 4 months and I am closely edging my way to victory. I have a module called ‘What to do when your covered calls are in-the-money’ and cover this topic in more detail inside my Options Selling Roadmap course. 

    Kevin S

    Kevin S

    Greetings, I'm Kevin! I am now a full time options trader and investor. I am thrilled to have the opportunity to share my knowledge and expertise with you. My objective is to assist you in navigating the complexities of option trading, regardless of whether you're a beginner or an experienced trader looking to enhance your skills. I'm excited to accompany you on your journey to mastering the art of option trading. Let's make this year an extraordinary one for you!
    Kevin S

    Kevin S

    Greetings, I'm Kevin! I am now a full time options trader and investor. I am thrilled to have the opportunity to share my knowledge and expertise with you. My objective is to assist you in navigating the complexities of option trading, regardless of whether you're a beginner or an experienced trader looking to enhance your skills. I'm excited to accompany you on your journey to mastering the art of option trading. Let's make this year an extraordinary one for you!

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