Wednesday, November 11, 2009

ITM vs OTM Covered Calls

Let's superficially address the choice between ITM and OTM Covered Calls...

We must remember that when the option is american stye, such option are exercizeable even before its expiration date. european options can be exercised only on expiration date. most stock options are american style and several indexes options are european style.

So, if CROX is at $8 and I choose to Sell $7 strike Call, an ITM Call, I risk being early exercised; which means, at any time before option expiration date, my existing Long CROX shares can be "called away"; ie, I am "forced" to sell my shares away at $7. If this happens....the Covered Call play is over even before it can reap any benefits...

The choice of any option strategy is usually decided by the intention of the trade. Thus, we must clearly understand the purposes of Covered Calls... In my mind, these are the main few :

a) Attempt to generate consistent income from existing Long stocks (this can be achieved by Selling either ITM, OTM or even ATM Calls)
b) Provide some downside cushion in stock price (the premium from Selling Calls mitigates small losses from price adverse movement)
c) A predetermined profit exit point (usually with Short OTM Call)
d) Achieve a higher Return on Investment, when the Short Call is exercised and existing stocks are "called away" ("If called" ROI is always higher essentially due to extra premium earned)

I am hoping that we can use GREEKS to explain and decide on why Covered Calls strike should be ITM, ATM or OTM ? and whether to use nearer or further dated options?

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