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“There is less risk using deep in-the-money (ITM) long calls than buying stock and selling the corresponding short calls”. That is the case John made to me when I received his email in January 2018. As an example, John used a $100.00 stock and a call premium of $9.00. The basis of his theory was that call options cost much less than the corresponding stock shares and therefore the amount of capital risk is much lower while upside is unlimited. John suggested buying deep ITM call options with expirations about 6 months out and rolling the options 2-3 months prior to expiration in order to avoid significant time value erosion. When considering when to sell the call if share price declined significantly, John proposed to use IBD’s 7% guideline so when share price moves down by the 7% threshold, the call option (s) should be sold. I thought it would be instructive to look at the pros and cons of this approach as all strategies have advantages and disadvantages and there is never a free lunch.

 

Advantages of using deep ITM long calls

  • Requires less cash per-position thereby allowing for greater diversification
  • Deep ITM calls have Deltas approaching 1.00 and will therefore behave much like a stock in terms of price movement
  • We are managing only 1 position, covered call writing requires 2 positions (long stock and short call)
  • There is no cap on the upside creating a situation for greater potential returns

 

Disadvantages when share price declines

Capital risk

It is true that we are risking less capital per-position but from a percentile perspective we are much more susceptible to losses. Let’s use John’s example with the $100.00 stock:

  • XYZ: $100.00
  • $91.00 call with a 6-month expiration: $9.00 (probably a few pennies of time value but we’ll round down to $9.00)
  • $91.00 call has a Delta near 1.00
  • Share price drops 7% to $93.00
  • Call value drops to $2.00 ($9.00 – $7.00) if Delta remains at 1.00
  • Delta will not actually remain at 1.00 as stock price approaches the strike price so let’s estimate the call value to be at $3.00, assigning a time value of $1.00 in addition to the $2.00 of intrinsic value
  • Option value drops from $9.00 to $3.00 or by 67% compared to the 7% decline in share value

 

Rolling options

Rolling options when on the buy side will almost always create a net debit because of the additional time value component of the longer term contracts. Although we are decreasing the loss of time value premium in the shorter-term contracts, we are paying the additional time value for the longer-term expirations. The concept of rolling long-term option 2-3 months prior to expiration when using The Poor Man’s Covered Call Strategy is a good idea because we are committed to the underlying for the long-term (using LEAPS) and this is where we will get the greatest benefit (smallest net debit).

 

Dividend factor

Covered call writers will capture corporate dividends as long as they own the shares on the ex-dividend date. Holders of long calls do not capture dividends. Furthermore, on the ex-date, the value of the stock will decline by the dividend amount and so will the corresponding deep ITM call. These calls must make up for time value erosion plus any price decline due to dividend distribution to generate a profit.

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Discussion

Buying deep ITM call options creates the opportunity for large profits to the upside. The risk is in the percentage loss potential when stock price declines as Delta must overcome Theta (time value erosion) and dividend losses. Those on the buy side of options must have a higher risk-tolerance than those on the sell side (covered, of course).

 

Upcoming events

Denver Colorado: American Association of Individual Investors

August 18 @ 9:00 am – 12:00 pm

Saturday August 18, 2018

Details to follow.

San Francisco Money Show

August 23 @ 10:00 am – 11:00 am

Hilton San Francisco Union Square

1.Thursday August 23rd: 11:30 AM – 12:15 PM

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All Stars of Options: How to Select the Best Covered Call Options in Bull and Bear Markets

2. Friday August 23rd: 10:15 AM – 1:15 PM

Masters Class: How to Generate Monthly Cash Flow and Buy a Stock at a Discount Using 2 Low- Risk Option Strategies (covered call writing and selling cash-secured puts)

Click for information

Market tone

This week’s economic news of importance:

  • Retail sales June 0.5% (as expected)
  • Business inventories May 0.4% (0.3% last)
  • Industrial production June 0.6% (as expected)
  • Home builders’ index July 68 (68 last)
  • Housing starts June 1.173 million (1.303 million expected)
  • Building permits June 1.273 million (1.301 million last)
  • Weekly jobless claims 7/14 207,000 (224,000 expected)
  • Leading economic indicators June 0.5% (0.0% last)

 

THE WEEK AHEAD

Mon July 23rd

Tue July 24th

  • Markit manufacturing PMI July
  • Markit services PMI

Wed July 25th

Thu July 26th

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  • Weekly jobless claims 7/21
  • Durable goods orders June
  • Housing vacancies Q2

Fri July 27th

  • Gross domestic product Q2
  • Consumer sentiment July

For the week, the S&P 500 moved up by 0.02% for a year-to-date return of 4.80%

Summary

IBD: Market in confirmed uptrend

GMI: 5/6- Bullish signal since market close of July 9, 2018

BCI: Using an equal number of in-the-money and out-of-the-money strikes. Going into the August contracts cautiously.

WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US

The 6-month charts point to a neutral tone. In the past six months, the S&P 500 was up 0% while the VIX (12.86) moved up by 20%.

Wishing you much success,

Alan and the BCI team

 

 



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