"Deep ITM Covered Call Without Shares?"

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"Deep In The Money Covered Call Without Owning The Underlying Shares?"

"I am a relative newbie in Option trading and have been following your website very closely. I am trying to understand writing Deep In-The-Money Covered Calls (Deep ITM CC).Can I write Deep ITM Covered Call if I don''t already own the shares? If yes, then I assume I can write those Deep ITM CC naked/margin, because I cannot buy the underlying stock lower than its current price (eg. I cannot buy AAPL for $240 when it is currently trading ~$260). If that is the case and I write Deep ITM CC naked/margin, what happens if the stock get assigned at the lower price (eg. $240) for which I wrote Deep ITM CC? Will I have to buy those shares at $260 from the market and sell it for $240 at a loss. Am I making sense?"
Asked By Sabasu on 9 July 2010

Answered by Mr. OppiE

Hi Sabasu,

Deep in the money covered call is such a safe strategy basically because no matter how the underlying stock moves, the price of the stock and the price of the deep in the money call options compensate each other so that no loss nor gain would be made on the underlying stock move at all. Profit is therefore solely from the extrinsic value remaining in the call options that are written, which can be safely made upon expiration or assignment. This is why the Deep in the money covered call is as close to being an options arbitrage as it can get for amateur options traders.

Now, you don't need to have already owned the underlying stock a long time before writing the call options. In fact, you can do both orders at once, buying AAPL shares for $260 and then writing the $240 call options. That's right, you don't need to have bought AAPL shares at $240 in order to write call options at $240. In fact, you can write those call options at whatever strike price you want to. There are no restrictions. In order to make the Deep in the money covered call work, you will need to write call options with delta value of 1 or extremely close to 1. So, in this case today with AAPL at $259.62, you will need to write at least the August $190 strike price call options with delta value of 0.99 (which is extremely close to 1) and contains $0.33 of extrinsic value left as profit. The $240 strike price call options you mentioned in your question contains only 0.74 delta which is insufficient as a complete hedge against direction risk. This means that if AAPL falls, your position will make a loss, defeating the purpose of using a deep in the money covered call in the first place.

So, what happens if your deep in the money covered call position gets assigned? In fact, most deep in the money covered call positions get assigned before expiration due to the fact that the call options written are so much in the money. So, is that a bad thing? Not at all! In fact, when you write deep in the money call options, you want to be assigned as quickly as possible so that both the stock and the option will disappear from your account leaving behind the extrinsic value of the call options written as profit in your account instantly! Lets see what happens:

Deep in the money Covered Call Early Assignment Assuming you bought 100 shares of AAPL at $259.62 for $25,962. You then wrote 1 contract of AAPL's Aug $190 strike price call options at $69.95 per contract, getting a credit of $6,995. Assuming your call options got assigned immediately. Your 100 shares of AAPL stocks got sold at $190 for $19,000 at a loss of $6,962. The call options disappear and you gain the whole $6,995 as profit. You make a profit of $6,995 - $6,962 = $33

Now, what if you did not have the money to buy the underlying stock? Then you most probably won't have enough cash as margin to write those deep in the money call options either. First of all, when you write naked call options without owning the underlying stock, you are not doing deep in the money covered call anymore because your call options are not "covered" by the ownership of the underlying stock. As such, your naked call write position will make a profit when the price of the underlying stock drops and will make a loss when the price of the underlying stock rises. Such a position does not have the deep hedged safety of a properly executed deep in the money covered call.


In conclusion, if you want to make a safe, almost risk free profit, using the deep in the money covered call, you will need to buy the underlying stock along with writing the deep in the money call options. In fact, you would need almost as much cash as buying the underlying stock as margin if you want to write the call options without buying the stock itself. Doing so also defeats the whole purpose of the stratey as a safe, hedged, strategy.