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.
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).
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
- Existing home sales June
Tue July 24th
- Markit manufacturing PMI July
- Markit services PMI
Wed July 25th
- New home sales June
Thu July 26th
- 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,