What Is a Deep in the Money Covered Call and How Does It Work?

Selling covered calls is a common strategy for generating income from stocks, but some investors take it a step further by selling deep in the money covered calls. This approach involves selecting strike prices significantly below the current stock price, leading to higher premiums and different risk-reward dynamics compared to standard covered calls.

While this strategy provides immediate cash flow, it also comes with trade-offs. Understanding how deep in the money covered calls work, along with their benefits and risks, is essential before implementing them in a portfolio.

Core Components of a Deep in the Money Covered Call

Executing this strategy requires understanding key elements that influence its performance. Each component affects the overall risk, reward, and profitability of the trade.

Underlying Asset

The foundation of a covered call trade is the stock or security the investor owns. Selling a call option obligates the seller to deliver shares if exercised, so holding the underlying asset ensures the trade can be fulfilled without additional purchases.

For deep in the money covered calls, stock selection is particularly important. Investors often target highly liquid stocks with narrow bid-ask spreads to reduce transaction costs. Stocks with lower volatility help manage risk, as sharp price swings can lead to unexpected losses. Dividend-paying stocks may provide additional income, but early assignment is more likely if the ex-dividend date falls before expiration.

Strike Price

The strike price in a deep in the money covered call is set well below the stock’s market price, making early exercise highly probable. The lower the strike price, the higher the premium received, but this also limits capital appreciation since the shares will likely be called away.

A deeper in the money strike price makes the option behave more like the stock itself, increasing sensitivity to price movements. While this can be beneficial in certain market conditions, it also raises exposure to downside risk. Investors must balance collecting a larger premium with the trade-off of capping potential gains.

Expiration Date

The time until expiration affects the trade’s return dynamics. Shorter expirations generate lower premiums but allow for quicker reinvestment into new trades. Longer-term options offer higher premiums but expose the investor to greater stock price fluctuations over time.

If the goal is frequent income generation, shorter expirations may be preferable. For those seeking larger premiums with fewer adjustments, longer-dated options might be more suitable. Time decay, or theta, accelerates as expiration nears, influencing decision-making when managing the trade.

Premium

The premium received from selling the call option provides immediate income and is a key factor in the strategy’s return potential. A deep in the money call generates a significantly higher premium than an at the money or out of the money call due to its intrinsic value.

Premium size depends on the stock’s volatility, time to expiration, and market conditions. While a higher premium offers immediate cash flow, it also signals a higher probability of assignment. Investors should assess the risk-reward balance carefully, as a large upfront premium does not guarantee a higher total return if the stock moves unfavorably.

Since deep in the money options behave similarly to stock ownership, changes in the stock’s price have a more pronounced impact on the position, requiring close monitoring.

Premium Calculations

Calculating the premium for a deep in the money covered call involves analyzing intrinsic and extrinsic value. Intrinsic value is the difference between the stock’s price and the option’s strike price, representing the immediate value if exercised. Since deep in the money calls have strike prices well below market value, most of the premium comes from intrinsic value.

Extrinsic value, or time value, represents the additional amount an investor pays for the possibility of further price movement before expiration. This component declines as expiration nears, with time decay accelerating in the final weeks.

Volatility significantly impacts the premium. Higher implied volatility increases the extrinsic portion, as larger price swings raise the probability of movement beyond the current range before expiration. However, deep in the money calls have less extrinsic value than at the money or out of the money options, making them less reliant on short-term price fluctuations.

Interest rates and dividend expectations also affect premium pricing. Rising interest rates generally increase call option premiums, as holding shares instead of cash carries an opportunity cost. If a company is expected to pay dividends before expiration, the option’s price may adjust to reflect the likelihood of early exercise. Investors should consider these factors when selecting contracts.

Reporting Option Exercises

When a deep in the money covered call is exercised, it triggers tax and accounting implications. The most immediate consequence is the sale of the underlying stock at the strike price, establishing the proceeds for capital gains or losses.

The difference between the stock’s purchase price and the strike price determines the taxable gain or loss. If the stock was held for more than a year before assignment, the gain qualifies for long-term capital gains treatment, taxed at rates ranging from 0% to 20% in 2024, depending on taxable income. If held for a year or less, the gain is taxed as ordinary income, with rates up to 37%.

The premium received from selling the call option is added to the sale proceeds rather than reported separately as income. For example, if an investor bought shares at $50, sold a covered call with a $40 strike price for a $12 premium, and the option was exercised, the total sale proceeds would be $52 per share ($40 strike price plus $12 premium). This affects the final gain or loss calculation and can influence tax planning, such as offsetting gains with capital losses.

Brokerage firms issue Form 1099-B to report security sales, including assigned stock from exercised options. However, these forms may not always reflect the correct cost basis, particularly when option premiums are involved. Investors should verify tax documents and adjust manually if necessary when filing Form 8949 and Schedule D with the IRS. Keeping detailed records, including trade confirmations and transaction history, helps prevent errors and potential IRS scrutiny.

Margins and Collateral

Using deep in the money covered calls within a margin account introduces considerations related to leverage and collateral requirements. Since the strategy involves holding shares while selling call options, margin accounts can enhance capital efficiency. Brokerages often allow investors to use the underlying stock as collateral, reducing the cash required to maintain the position.

Margin requirements vary based on stock volatility, option depth, and broker risk models. Regulation T, enforced by the Federal Reserve, mandates a 50% initial margin requirement for stock purchases, but covered calls generally have lower requirements since the short call is secured by owned shares.

Maintenance margin rules also apply, particularly if the stock price declines significantly. If the stock’s value drops, the account may face a margin call, requiring additional funds or securities to restore compliance. Portfolio margin accounts, which assess risk based on overall exposure rather than fixed percentages, may offer more flexibility for traders executing this strategy at scale.