In-The-Money Covered Call Writing: Management Techniques

Updated: May 3


Daniel W., who became a premium member last week and immediately signed up for a 1-on-1 online meeting, asked me the following question:

How do we manage an in-the-money covered call with 9-12 months to expiration? Also important to note: what if we don't want to incur negative tax consequences?

Let's dive into the spreadsheets and provide a profound answer to Dan's question.

Declining Stock Price: Progressive

Last week, I discussed in-the-money covered call writing on Progressive (PGR).

(Source: Option Generator's Spreadsheet)

Let's review the $77.50 strike price as the stock has since declined. What if we decide to unwind this position today? Stated differently, what would our return look like? Let's put the unwinding tab of the calculator to work.

(Source: Option Generator's Spreadsheet)

* Note: we haven't yet been entitled to PGR's dividends, which is why the 40 cent dividend is excluded from the calculations.

Our return would be -2.28% for the entire trade setup versus -6.7% for the buy and hold investor. However, there's still plenty of time value in the option, namely a 11.48% return (cost-to-close) that hasn't yet been earned.

Is it realistic to assume that we can generate an 11.48% return over the next 9 months? Probably yes, but that's not the purpose of this in-the-money covered call strategy. The main goal is to set up a trade for the coming 9 months while avoiding 'intervention'. We know our breakeven point beforehand and as part of a defensive portfolio, doing nothing is oftentimes a fair decision.

Since PGR's share price is still above the $70.17 breakeven, unwinding makes little sense. Remember: as long as the stock price remains above the strike price at expiration in January 2021, we've maxed out our maximum return potential. The intrinsic value component of the option we sold compensates us for the loss on the stock side ($82.87 - $77.50 = $537 per 100 shares).

Surging Stock Price And Collapsing Implied Volatility: Zoetis

On March 17th, we entered several in-the-money covered calls on Zoetis for the defensive part of the wealth management portfolios. The stock was trading at around $110; the $90 strike at $36.50. The following outcomes appear.

(Source: Option Generator's Spreadsheet)

We were able to capitalize on a possible 25.7% annualized return (when re-investing the entire cash premium received). Our breakeven point stood at 34.27% lower than $110. As witnessed in more stocks, Zoetis saw a powerful V-shaped recovery in its share price:

(Source: Pro Real Time)

What happened to our in-the-money covered call?

The $90 call is now trading at $40.60 per contract. This, in turn, means that 81.39% of the initial time value has already been collected. Does it make sense to keep this position open, or should we initiate operation "Portfolio overwriting"?

(Source: Option Generator's Spreadsheet)

If we now opt for unwinding, it would make total sense:

(Source: Option Generator's Spreadsheet)

The cost-to-close is 3.41%, or 0.4% for the next 9 months. Can we generate profits that exceed this return by utilizing one position? The answer to that: pretty ease. Our realized return stands at 14.92%, not so bad. How come we have generated such return this fast? A collapse in implied volatility has destroyed the value of long-term options. That's precisely the reason why selling in-the-money calls is the most appropriate vehicle for defensive investors in high-IV circumstances.

(Source: Market Chameleon)

Now, coming back to the relevant question of Daniel: how do we circumvent negative tax consequences? As Zoetis has been a stellar performer over the past years and months, holding onto the position is our number one priority. There are a couple things an investor like Daniel could do.

1. Buying back the current short call, holding onto the stock and selling a new in-the-money call. Why the heck would we do that? Because Daniel is still enticed to a defensive trade setup and a $110 call strike fits the bill with volatility at the upper end of its range. What are the consequences and what are the returns?

  • We own Zoetis at $110

  • We still have realized a gain of 14.92% on the in-the-money $90 call although our intention is not the sell the stock (the intrinsic value we have to pay to buy back the short call is being compensated for by the additional capital gains on ZTS from $110 to $127.53)

  • Selling the $110 call for January 2021 yields the following returns (attention: we now use $127.53 as the comparative stock price, not the $110 cost basis, so we view the $110 in-the-money covered call as an entirely new position based on current market data!)

(Source: Option Generator's Spreadsheet)

Adding the 6.80% return (without re-investing the cash premium) to the realized return of 14.92%, we now have not only exceeded the cost-to-close of 3.41% of the first in-the-money covered call ($90 strike), but can also capitalize on a total 18.3% return. We still own the shares of Zoetis and do not incur negative tax consequences because of capital gains.

2. Turning to portfolio overwriting: selling out-of-the-money covered calls (appropriate right now)

3. Implementing complex strategies when volatility is low/normal (not appropriate right now!)


Personally, I would favor the second option because Zoetis currently enjoys one of the highest ratings on our long-term winners watchlist. By choosing the portfolio overwriting approach, we can generate monthly option premium returns of 2+ % while allowing for capital appreciation, thus avoiding the negative tax iss

Option Generator AM

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