Anyone just starting out in covered calls needs to decide if they want to focus on an in-the-money (ITM) or an out-of-the-money (OTM) strategy. This is a significant decision that will have important effects on your long term success and that amount of success.
Benefits of ITM
(1) More Protection: ITM strategies obviously offer more downside protection than OTM. You will make the same amount if the stock goes up, stays flat, or goes down to a certain percentage that it is ITM. (%ITM is the % the stock must drop to reach the strike price {$purchased - $strike}/$purchase)
This is a HUGE advantage because ITM systems are more forgiving of price fluctuations and mistakes on the trader's part.
(2) Since an ITM trader is more likely to be called out at the end of the month, every month you will research and find the highest yielding CC positions that meet your requirements. Compared to an OTM strategy, you are more often left with the stock at the end of the month since it did not rise to the strike price. When you write another call for the next month it may not have a high premium anymore because the "market excitement" that caused the premium to be high in the first place has disappeared for whatever reason (for example a quarterly earning report was what initially caused that excitement has passed).
I believe this reason is very minor compared to the first one. It can probably be ignored, but I added it for completeness.
(3) In a down-trending market, which happens about 30% - 40% of the time, an OTM strategy simply does not work. This is because the vast majority of stocks follow the market to an extent (defined as Beta). It is very hard to find up-trending stocks in a down-trending market. So in a downward market a CC trader can select positions perhaps 6% ITM or more and be successful. However in this scenario, the premium received will be much smaller than in an upward market so the trader must trade with enough money per position to prevent trading costs taking up all his gains.
Disadvantage of In-the-Money and Advantages of Out-of-the-Money
(1) Trading Costs: Since an ITM strategy has more positions called out at the end of the month, trading costs will be higher. In a scenario where the stock is flat, there will be two stock orders and on option order for an ITM position vice on stock order and one option order in an OTM position.
(2) Higher R-multiples in ITM: The max R-multiple is the ratio of the max amount gained divided by the amount lost if the position is stopped out. Since OTM positions make more money if the stock goes up, the max R-multiples are higher for OTM positions. Thus OTM strategies follow more to an extent the old trading adage "letting your profits run." (I say "to an extent" because all CC strategies limit the upside, regardless if it is ITM or OTM.) This is why OTM strategies can potentially be more profitable, but more risky.
(3) Since in an ITM strategy, you will be called out more frequently at the end of the month, you will need to research more positions every month. This will take more of your time (whether this is good or bad depends on you). In an OTM strategy, you will more often NOT be called out. Then you would simply sell another option on the same stock that would give the highest premium. This saves time because the majority of your research time is on the stock, not the option.
(4) For my next point, you need to understand one of the four greeks: delta.
In options, delta is the amount an option goes up or down when the underlying stock goes up or down by $1.00. Options ITM have deltas closer to 1.0 compared to options that are OTM.
So for example, say you are in an ITM position that the stock just went up $3. The option has a delta of 0.8, so the option went up by $2.40 ($3 * .8), which is a debit in your account. So in total your position went up $3 - $2.40 = $0.60.
In another example, you are in an OTM position that went up $3 whose option delta is 0.6. Thus the option went up $1.80 (or debit in your account) and your total position went up $3 - $1.8 = $1.20.
It is the OTM scenario where you are easier able to do a roll-out to capture a quick gain in the stock. (A roll out is buying back the call and selling the stock prior to expiration). This is much harder in an ITM strategy because when the stock jumps, so does the option by almost the same amount.
This is a HUGE advantage to OTM strategies. A good OTM CC trader will use auto-roll-outs frequently. In these cases, he would not have made as much money if he would have waited until the end of the month, but rolling out early completely removes the risk of the stock dropping again later. Additionally, he can take that money and re-invest it in another position. Like I said before, this is a HUGE benefit to OTM traders.
Which Strategy is best for Me?
In a downward market, an ITM strategy should be the only option. Some will look at a covered call screener and still see high yielding OTM positions. However, these stocks are more likely to head south and you will be stopped out. Remember, 100% of the risk is in the stock.
In an upward market, I initially thought that the only people who should trade OTM are people who fully understand the concepts of position sizing and expectancy. But any CC trader should understand these concepts (see Trade your Way to Financial Freedom by Dr. Van Tharp)
I now believe based on my own experience that whether or not someone should trade OTM CC's is based on one thing: experience. It strongly recommend that any OTM trader should have prior experience as a trader of any kind. This experience can be an ITM strategy or any sort of other system.
Another option if you think you are somewhere in the middle is to trade both ITM and OTM. Perhaps you could have half of your positions in ITM and the other half in OTM.
Article Source: http://EzineArticles.com/?expert=Fred_Thompson
Benefits of ITM
(1) More Protection: ITM strategies obviously offer more downside protection than OTM. You will make the same amount if the stock goes up, stays flat, or goes down to a certain percentage that it is ITM. (%ITM is the % the stock must drop to reach the strike price {$purchased - $strike}/$purchase)
This is a HUGE advantage because ITM systems are more forgiving of price fluctuations and mistakes on the trader's part.
(2) Since an ITM trader is more likely to be called out at the end of the month, every month you will research and find the highest yielding CC positions that meet your requirements. Compared to an OTM strategy, you are more often left with the stock at the end of the month since it did not rise to the strike price. When you write another call for the next month it may not have a high premium anymore because the "market excitement" that caused the premium to be high in the first place has disappeared for whatever reason (for example a quarterly earning report was what initially caused that excitement has passed).
I believe this reason is very minor compared to the first one. It can probably be ignored, but I added it for completeness.
(3) In a down-trending market, which happens about 30% - 40% of the time, an OTM strategy simply does not work. This is because the vast majority of stocks follow the market to an extent (defined as Beta). It is very hard to find up-trending stocks in a down-trending market. So in a downward market a CC trader can select positions perhaps 6% ITM or more and be successful. However in this scenario, the premium received will be much smaller than in an upward market so the trader must trade with enough money per position to prevent trading costs taking up all his gains.
Disadvantage of In-the-Money and Advantages of Out-of-the-Money
(1) Trading Costs: Since an ITM strategy has more positions called out at the end of the month, trading costs will be higher. In a scenario where the stock is flat, there will be two stock orders and on option order for an ITM position vice on stock order and one option order in an OTM position.
(2) Higher R-multiples in ITM: The max R-multiple is the ratio of the max amount gained divided by the amount lost if the position is stopped out. Since OTM positions make more money if the stock goes up, the max R-multiples are higher for OTM positions. Thus OTM strategies follow more to an extent the old trading adage "letting your profits run." (I say "to an extent" because all CC strategies limit the upside, regardless if it is ITM or OTM.) This is why OTM strategies can potentially be more profitable, but more risky.
(3) Since in an ITM strategy, you will be called out more frequently at the end of the month, you will need to research more positions every month. This will take more of your time (whether this is good or bad depends on you). In an OTM strategy, you will more often NOT be called out. Then you would simply sell another option on the same stock that would give the highest premium. This saves time because the majority of your research time is on the stock, not the option.
(4) For my next point, you need to understand one of the four greeks: delta.
In options, delta is the amount an option goes up or down when the underlying stock goes up or down by $1.00. Options ITM have deltas closer to 1.0 compared to options that are OTM.
So for example, say you are in an ITM position that the stock just went up $3. The option has a delta of 0.8, so the option went up by $2.40 ($3 * .8), which is a debit in your account. So in total your position went up $3 - $2.40 = $0.60.
In another example, you are in an OTM position that went up $3 whose option delta is 0.6. Thus the option went up $1.80 (or debit in your account) and your total position went up $3 - $1.8 = $1.20.
It is the OTM scenario where you are easier able to do a roll-out to capture a quick gain in the stock. (A roll out is buying back the call and selling the stock prior to expiration). This is much harder in an ITM strategy because when the stock jumps, so does the option by almost the same amount.
This is a HUGE advantage to OTM strategies. A good OTM CC trader will use auto-roll-outs frequently. In these cases, he would not have made as much money if he would have waited until the end of the month, but rolling out early completely removes the risk of the stock dropping again later. Additionally, he can take that money and re-invest it in another position. Like I said before, this is a HUGE benefit to OTM traders.
Which Strategy is best for Me?
In a downward market, an ITM strategy should be the only option. Some will look at a covered call screener and still see high yielding OTM positions. However, these stocks are more likely to head south and you will be stopped out. Remember, 100% of the risk is in the stock.
In an upward market, I initially thought that the only people who should trade OTM are people who fully understand the concepts of position sizing and expectancy. But any CC trader should understand these concepts (see Trade your Way to Financial Freedom by Dr. Van Tharp)
I now believe based on my own experience that whether or not someone should trade OTM CC's is based on one thing: experience. It strongly recommend that any OTM trader should have prior experience as a trader of any kind. This experience can be an ITM strategy or any sort of other system.
Another option if you think you are somewhere in the middle is to trade both ITM and OTM. Perhaps you could have half of your positions in ITM and the other half in OTM.
Article Source: http://EzineArticles.com/?expert=Fred_Thompson
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