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Take a look at following option chain, it's for some company in Indian markets,

enter image description here

I intend to do a covered call on the stock but I would want a little extra downside protection at the cost of little premium.

So I can Sell strike 730 Call for Rs 85.10 with a time premium of around Rs. 34.00, while ATM Call at strike 780 is priced at Rs. 46.20. Another example: enter image description here

Here ATM call with strike 355 is priced at Rs. 13.50, but if I go deeper in the money and look at strike 315 which is priced at Rs. 51.05 with a time premium value of Rs. 12.03 which is very very close to ATM strike premium but with far better downside protection, but in this case Theta is different for both strikes.

Now my question is how is it that even such deep in the money calls have such high premiums, is it some kind of price inefficiency or they actually have such high time premiums, if so Is it better to sell deep in the money covered calls rather than ATM calls for better downside protection at the cost of little premium?

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    Assuming "LTP" denotes "Last Trade Price", this would imply that the strike price premiums you have highlighted have not traded recently. If you wish to see the current state of play, then you want to look at the current bid and offer prices, not the last trade price. – Nick Dec 22 '18 at 5:53
  • Yes you are right these are prices for last trading day not the real time prices as markets are closed as of now. Assuming if we get these prices (I can look at bid and ask prices) in live markets would it be wise to sell covered calls deep in the money or is there some other catch? – Vibhore Tanwer Dec 22 '18 at 6:05
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    Deeply in the money options do not trade frequently. The "LTP" may be days, or even weeks old. When selling a covered call option one normally sells out of the money strikes with the intention of enhancing income from your underlying holding. If you are selling deeply in the money calls then you increase the risk having your underlying holding "called away". – Nick Dec 22 '18 at 6:13
  • Thanks for your help Nick, I am trying to apply Covered Call a little differently here, I will be doing this only with index futures so not concerned about stock being called away since index options or any options in Indian markets are only cash settled, also I am planning to profit only from the premiums earned through the options sold and not concerned about giving away all upside potential, Hence in this strategy only risk I see is on the downside which I am trying to protect by using In the money options. – Vibhore Tanwer Dec 22 '18 at 6:22
  • The covered call strategy can be implemented when mildly bearish (sell ITM), neutral to mildly bullish (sell ATM) or bullish (sell OTM). OTM is appropriate for selling at a target exit price. One who utilizes the strategy strictly for income, not growth, wants assignment and loss of underlying to occur in the shortest time possible, maximizing ROI. – Bob Baerker Dec 22 '18 at 13:50
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Let's start with a small correction to your second example. The underlying is 354.20 and the 315 call is 51.05 . That means that the intrinsic value is 39.20 and the time premium is 11.85 . Still quite hefty but not realistic. As mentioned in the comments, these are closing quotes and will not be reflective of the actual market since illiquid options may have traded minutes, hours or even days before the closing price of the underlying. See real time prices.

Based on the implied volatility of the 355 call, the premium for the 315 call should be closer to 10 points lower. There is no price inefficiency here.

Choice of strike price is a trade off between risk and reward:

  • Selling a lower strike provides more premium, more downside protection with a lower potential profit.

  • Selling a higher strike provides less premium, less downside protection with a higher potential profit.

The optimal result is attained by knowing what share price is going to be at expiration. Since that can’t be known, you have to find a balance between the two choices. What's your motivation for the position, fear or greed?

Covered calls are synthetically equivalent to short puts. If you have the approval and the numbers are good, selling the put has the potential for fewer commissions and incurring fewer B/A spread costs.

A covered call has an asymmetric risk profile with a limited upside while bearing most of the downside risk. So unless you have some secret sauce that gives you superior timing and selection, I'd suggest that you consider strategies with a better risk profile (vertical or diagonal spreads). These would have a modestly lower profit potential while greatly reducing the risk, shifting the R/R from asymmetric to much closer to balanced.

An alternative approach to these strategies would be to use high delta ITM calls as the long leg, reducing the risk should a collapse in the underlying occur (Google "Stock Replacement Strategy" and "Poor Man's Covered Call").

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