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This is a level 2 question.
I found a stock trading at 22.50, and the February 20 call option is priced at 4.50. If I buy the stock and sell the call option, it would be a covered call with the call in the money. If I am exercised and have to sell the stock at 20, do I make a profit of 2.00? Assume I don't care if the stock is taken from me. Is this a valid strategy?
Writing in-the-money covered calls is a viable strategy. However, in-the-money covered calls have lower profit potential than out-of-the-money covered calls. For example, let's say an investor wanted to write a covered call on stock ABC, which is currently trading at 34. He could write the in-the-money November 30 call, which is bid at 4.50, or he could write the out-of-the-money November 40 call, which is bid at 0.75. The maximum profit for the in-the-money call is 0.50 and will occur if the stock closes above 30 at expiration and the stock is called away. The maximum profit for the out-of-the-money call is 6.75 and occurs if the stock price closes above 40 at expiration. The in-the-money alternative is more conservative since the stock can actually fall four points, and the trade will still achieve maximum profits.
To address your example specifically, your understanding of this trade's profit potential is correct. However, the option price seems unusually high. In your example, the option's intrinsic value is 2.50 (stock price of 22.50 less strike price of 20), leaving time value of 2.00. This represents 44 percent of the option's value, which is a very high proportion of time value. Such a large percentage of time value is very rare and would likely occur on options with high implied volatilities.
Keep in mind that with such high time value, it is unlikely that your in-the-money call will be exercised at a stock price of 22.50. Why? Simply because there is no incentive for the option holder to do so. If the buyer paid 4.50 for the call, his breakeven is a stock price of 24.50, and there is no incentive for him to exercise below this price. Let's say the stock goes to 25 before expiration. Your call gets assigned and you give up your shares at 20, losing 2.50 per share on the stock sale. However, you made 4.50 in premium for a net gain of 2.00 per share, or $200 per contracts. On the other hand, if you had just bought the shares, you would have gained 2.50, or $250 per 100 shares.
Thanks for your question and good luck with your covered-call strategy.
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Question Level Key
Level One--Basic Jargon, Definitions, Basic Mechanics of Trading.
Level Two--Introductory Points, Practical Points and Simple Strategies
Level Three--More Advanced Strategies and Repairs
Level Four--Risk Management, Psychology, and How Best to Evaluate Things.
Level Five--High end questions concerning Portfolio Analysis, Managing a Portfolio
of Options, Option Pricing Models, and Nuances of Trading. Included could be a variety of
other topics.
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