Writing in-the-money calls is a good strategy to use if the options trader is looking to earn a consistent moderate rate of return.
Long 100 Underlying, Sell 1 ITM Call
Profit is limited to the premium earned as the writer of the call option will not be able to profit from a rise in the price of the underlying security.
Offers more downside protection as premiums collected are higher than writing out-of-the-money calls.
Limited profit
As the striking price is lower than the price paid for the underlying stock, any upward price movement will not benefit the call writer since he has agreed to sell the shares to the option holder at the lower striking price. Therefore, the maximum gain to be made writing in-the-money calls is limited to the time value of the premium at the time of writing the call.
Premium Received - Purchase Price of Underlying + Strike Price of Short Call - Commissions Paid
Profit achieved when: Price of Underlying >= Strike Price of Short Call
Greater downside protection
As the premiums received upon writing in-the-money calls is higher than writing out-of-the-money calls, downside protection is greater as the higher premium can better offset the paper loss should the stock price go down.
Unlimited
Loss occurs when: Price of Underlying < Purchase Price of Underlying - Premium Received
Loss = Purchase Price of Underlying - Price of Underlying - Max Profit + Commissions Paid
Breakeven point
Purchase Price of Underlying - Premium Received
Example
Suppose the stock XYZ is currently trading at $50 in June. An options trader decides to write a JUL 45 covered call for $7. He pays $5000 for the 100 shares of XYZ and receives $700 in premium giving a net investment of $4300.
The stock then rallies to $55 at expiration and the call gets assigned. As per the options contract, the trader has to sell the 100 shares of XYZ at the striking price of $45 and so he receives $4500 for the shares sold. Since his original investment is $4300, his net profit for the entire trade is only $200.
However, should the stock price go down to $45 instead, he still makes a profit since the $700 in premiums received more than offset the $500 in paper loss of the 100 shares he held which has lost $5 a share in value.
At $45, the call most likely will not get assigned since there is no intrinsic value left in the option. Since the shares did not get called away, the call writer can either sell the shares for $4500 giving him a net profit of $200 for the entire trade or write another call against the shares held.
Commissions
These examples exclude commissions and fees. Include all transaction costs when evaluating the profit or loss of a position.