Sell deep in the money option

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darrenmo

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I am pretty sure I misunderstand why people would sell deep ITM calls so please pick me up on anything that is wrong in the following statement:

If a stock price is $30 then selling a call option at $28 would be ITM. That means that I (the person selling the call) would receive a premium for giving someone else the right to buy my shares at $28, let's say it's $3/share premium.

What I have noticed is that if the strike price is near the money ($28 or $29) then the premium more than compensates for the loss. For example, if the stock price is $30 then selling a call option at $28 would give me $3 so I am $1 up. Selling a call option at $25 would give me $5.50 so I am $0.50 up. As we move further away from the money the profit get's smaller and smaller until there is a loss. Selling a call option at $15 would give me typically $13 so I am $3 down.

These figures are made up but it does reflect practically all options. If I (the person selling the call) am allowing someone to "call away" my shares at such a low price, why am I not being compensated? After all, it would be very unlikely that a share price drops from $30 to $15 and yet I am better compensated for near the money.

Why would anyone ever sell deep in the money?
 
If you sold your call option at strike $15 for $13 and the stock was trading at $15 on expiry then you'd make a profit of $13 on that trade. Do you not think that profit is a fair reflection of the risk you have taken on?
 
Hoggums said:
If you sold your call option at strike $15 for $13 and the stock was trading at $15 on expiry then you'd make a profit of $13 on that trade. Do you not think that profit is a fair reflection of the risk you have taken on?
Click to expand...

Hi Hoggums; Surely I wouldn't make $13 as I paid $30 for the stock in the first place so I'd walk away $3 down.

But I do now see that someone would only sell deep in the money if they thought the stock would drop. However, if you thought the stock would drop wouldn't it be wiser to short the stock to make money on it?

Sorry, I am a newby and very confused. My ultimate aim is to learn how to make a small guaranteed premium month after month writing call options. You're help is appreciated!
 
Martinghoul said:
Would you like me to elaborate? and maybe try to answer your question?
Click to expand...

I would appreciate that yes.

I may have something fundamentally wrong in my understanding. When selling a call, I am being paid a premium. When selling a Put (so as to give myself some insurance) I am paying someone else right?

Am I correct in thinking I would pay 0.03 to sell the $15 Put here: YHOO Options | Yahoo! Inc. Stock - Yahoo! UK & Ireland Finance

And that would mean I have the right to sell the stock to that person for $15 at any time before expiry?

Thank you.
 
No, that's incorrect...

When you sell options, regardless of whether they're puts or calls, you receive premium. Once you have sold an option, you have no rights :). Instead, the buyer has a right and you have an obligation, if the buyer chooses to exercise that right (in which case you are 'assigned'). If you have sold a put, your obligation is to buy; if you have sold a call, your obligation is to sell. And yes, most options on US equities are American, which means that, in theory, you can be assigned before expiry. However, this isn't a common occurrence by any means and the conditions under which it's likely to occur are somewhat difficult to explain without going into some very gory details.
 
How does exercise obligation on american options work if it's exchange traded? Who's the counter-party that decides to exercise?
 
Exercise isn't an obligation, it's a right. Whoever is long an option chooses whether they want to exercise or not. The only difference between European and American options is that, in theory, a long can decide to exercise an American option at any point in its life, whereas for a European option that decision can only be made at expiry. In reality, as I said, early exercise is rarely economic, which means that, for a beginner, it's easier to get some understanding of options by assuming they're all European.
 
Martinghoul said:
No, that's incorrect...

When you sell options, regardless of whether they're puts or calls, you receive premium. Once you have sold an option, you have no rights :). Instead, the buyer has a right and you have an obligation, if the buyer chooses to exercise that right (in which case you are 'assigned'). If you have sold a put, your obligation is to buy; if you have sold a call, your obligation is to sell. And yes, most options on US equities are American, which means that, in theory, you can be assigned before expiry. However, this isn't a common occurrence by any means and the conditions under which it's likely to occur are somewhat difficult to explain without going into some very gory details.
Click to expand...

Thank you for putting me straight Martinghoul.

I don't then understand why so many "gurus" state that a Put is like "buying insurance".

To to try and simplify the concept they describe selling a call as "renting" shares. They explain that you get paid rent or a premium for renting your shares and you can buy a Put as insurance. They even do the figures; "you make X amount of rent, MINUS what you've spent on the Put "insurance".

Just seems to be opposite from what you've explained as you should make "rent" PLUS extra rent for insurance?
 
darrenmo said:
Thank you for putting me straight Martinghoul.

I don't then understand why so many "gurus" state that a Put is like "buying insurance".

To to try and simplify the concept they describe selling a call as "renting" shares. They explain that you get paid rent or a premium for renting your shares and you can buy a Put as insurance. They even do the figures; "you make X amount of rent, MINUS what you've spent on the Put "insurance".

Just seems to be opposite from what you've explained as you should make "rent" PLUS extra rent for insurance?
Click to expand...
What the "gurus" are talking about when they talk about insurance is buying puts, rather than selling them. So a portfolio you're describing (it's sometimes referred to as a "collar") will look smth like this:
Long stock (say, currently at 100)
Short the 150 strike call
Long the 20 strike put

The payoff on a structure like the one above looks, unsurprisingly, like a payoff of a call spread. Specifically, your downside is limited, but at the expense of accepting a limited upside. Furthermore, I find that describing the whole "covered call"/"buy-write" strategy as a way to "rent" shares is a little misleading. Unless, of course, you enjoy not getting the stuff you have rented back. Still, everything has its place.
 
Martinghoul said:
Exercise isn't an obligation, it's a right. Whoever is long an option chooses whether they want to exercise or not. The only difference between European and American options is that, in theory, a long can decide to exercise an American option at any point in its life, whereas for a European option that decision can only be made at expiry. In reality, as I said, early exercise is rarely economic, which means that, for a beginner, it's easier to get some understanding of options by assuming they're all European.
Click to expand...

Rephrase. Who is obligated to settle if an american long is exercised early?
 
scose-no-doubt said:
there we go. Do I really come across that convoluted?
Click to expand...
A bit. More likely I was being slow.

The answer to your question is that it depends. OCC, for instance, distributes the assignments among brokers/clearers at random. Each broker/clearer is then responsible for choosing the "victims" from among its clients. How they do it is up to them. So it's exchange/broker dependent.
 
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