Markets Tumble: Why Selling In-The-Money Covered Calls Beats The Market Right Now

Introduction

The market took a serious beating last week. In this article I explain what new investors and conservative investors should do in order to generate a juicy return while enjoying downside risk protection in case of an escalating downturn. Volatility has spiked and that creates a lot of opportunities for smart investors looking for an attractive risk/reward profile by utilizing options.


American Tower

Let's use American Tower as the perfect example for high-quality dividend growth investors. Based on my metrics, this company enjoys a very strong technical and fundamental rating, especially during market turmoils.

Buy a stock that we have confidence in and sell an option which will decrease our cost basis and thereby increase our percent returns. In this case we need to turn to selling in-the-money calls which give us downside risk protection because of the intrinsic value that we're going to receive. Putting our calculators/spreadsheets (exclusively shared with our premium members) to work, the math will become a non-event. American Tower is an excellent dividend stocks as can be noticed below.

January 2022 Expiration

Before we get into great detail on how the mathematics behind this strategy play out, I'd like to share with you the two expiration dates I'll be using in this article: January 2022 and January 2021. I've used the mid-price of the spread between the bid and the ask. Also, there are 4 expected dividend payments between now and January 2021 and 8 distributions between now and January 2022.


Let's first have a look at an overview of the strikes and premiums we can generate by selling covered calls expiring in January 2022.

(Source: Option Generator's Spreadsheet)


The lower the call strike, the more intrinsic value, the more downside risk protection we have of the profit (time value). Please note that strike price selection always depends on your own personal risk tolerance. If capital preservation is our main goal, we should go with an in-the-money call of let's say the $180 strike.


How to interpret these numbers above? Well, the $180 strike price results in a 6.64% time value return, which is protected by the intrinsic value component of $46.80 (or 20.63% downside protection of the profit). Adding the dividends to the equation, we can generate a maximum return of 11.73% over the next 693 days. Our total breakeven stands at $158.89, which is considerably lower than the current market value of the stock.


$180 strike

The next bullet points highlight what the strategy boils down to if we opt for the $180 strike:

  • The amount that the option is in the money and thus the intrinsic value that we're going to receive from the call buyer = $46.80 per share. This figure compensates us for the loss on the stock side, since we're obligated to sell at $180

  • Our breakeven including the expected dividend distributions is $158.89, noticeably less than the current market value of the stock: higher chances of success/a lot of downside risk protection

  • Our cost basis is being bought down from $226.80 to $180 (strike price); this increases our percent return. Use the high cash premium (intrinsic value) to enter other new positions or compound your time value return instantaneously

  • Adding the dividend amount of $9.16 to the time value component of $11.95 per share leads to our actual profit. We're guaranteed the time value return as long as shares do not depreciate below $180 by expiration Friday in January 2022

  • Our total return is 11.73% over a 693-day time period; buying American Tower shares leads to a return of 4.00% based on the 8 expected dividend payments. So, we've increased our profit potential by 193%... On an annualized basis, we have the potential to generate a return of 6.01%

  • Although the option is in-the-money, the option buyer is not going to exercise our short call to capture the dividend prior to the ex-dividend date. So, we will capture the dividend distributions as long as the time value left in the option exceeds the quarterly dividend amount. Once we've entered this position, we must monitor the early assignment risk

  • Since the January 2022 LEAPs have small time decay, the evolution of American Tower's share price is going to determine how much time value there's left in the option we sold. If the cash distribution supersedes the time value component a day or two before the ex-dividend date, we have to roll out the option in order to be still eligible for dividend capture. At this point in time, the time value component exceeds all the ex-dividend amounts

  • When dealing with an in-the-money call, there's no possibility of participating in any share appreciation above the strike price as well

  • If the share price goes up dramatically and there's virtually no more time left in the option, early assignment may take place even prior to the ex-dividend date. We can then unwind the position to generate new time value in a completely new trade (see the topic on 'Exit Strategies)

(Source: Option Generator's spreadsheets)


January 2021 Expiration

Let's first have a look at an overview of the strikes and premiums we can generated by selling covered calls expiring in January 2021.

(Source: Option Generator's spreadsheets)


$180 strike

Let's have a look at the same $180 in-the-money call but with a shorter duration. The next bullet points highlight what the strategy boils down to if we opt for the $180 strike:

  • The amount that the option is in the money and thus the intrinsic value that we're going to receive from the call buyer = $46.80 per share. This figure compensates us for the loss on the stock side, since we're obligated to sell at $180

  • Our breakeven including the expected dividend distributions is $168.41, noticeably less than the current market value of the stock: higher chances of success/a lot of downside risk protection

  • Our cost basis is being bought down from $226.80 to $180 (strike price); this increases our percent return. Use the high cash premium (intrinsic value) to enter other new positions or compound your time value return instantaneously

  • Adding the dividend amount of $4.34 to the time value component of $7.25 per share leads to our actual profit. We're guaranteed the time value return as long as shares do not depreciate below $180 by expiration Friday in January 2021.

  • Our total return is 6.44% over a 322-day time period; buying American Tower shares leads to a return of 1.9% based on the 4 expected dividend payments. So, we've increased our profit potential by 239%... On an annualized basis, we have the potential to generate a return of 7.33%

  • Although the option is in-the-money, the option buyer is not going to exercise our short call to capture the dividend prior to the ex-dividend date. So, we will capture the dividend distributions as long as the time value left in the option exceeds the quarterly dividend amount. Once we've entered this position, we must monitor the early assignment risk

  • Since the January 2021 LEAPs have small time decay, the evolution of American Tower's share price is going to determine how much time value there's left in the option we sold. If the cash distribution supersedes the time value component a day or two before the ex-dividend date, we have to roll out the option in order to be still eligible for dividend capture. At this point in time, the time value component exceeds all the ex-dividend amounts

  • When dealing with an in-the-money call, there's no possibility of participating in any share appreciation above the strike price as well

  • If the share price goes up dramatically and there's virtually no more time left in the option, early assignment may take place even prior to the ex-dividend date. We can then unwind the position to generate new time value in a completely new trade (see the topic on 'Exit Strategies)

(Source: Option Generator's spreadsheets)


Conclusion

Selling an in-the-money call to combine the best of both worlds of dividend capture and downside risk protection presents opportunities in this market environment. Selling the $180 call expiring in January 2021 results in an annualized return of 7.33% and that's an appealing strike you might want to move forward with. We've increased our profit potential by 239%. On top of that, we incur less risk than the ordinary investor because of the intrinsic value component resulting a breakeven point of $168.41. American Tower is a great company that undoubtedly fits into this strategy.

Option Generator AM

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