by Russ Allen

The last couple of weeks' articles, which you can read here and here, dealt with the time value in a call option and its ups and downs. We'll polish off this series with a description of a strategy that can be used to generate a moderate amount of income with a relatively small amount of risk.

This is the in-the-money covered call, where we sell call options whose strike prices are lower than the present price of a stock that we own (or buy for the purpose). We fully expect to have the stock taken away from us in this strategy, and if that happens we make a pretty nice profit, which is equal to the time value in the call options. If the stock drops and does not get taken away from us, then we will still have reduced our net cost of that stock considerably. Here's how it works.

Let's say we believe that the price of oil, which has dropped by almost 50% in the last six months, will not fall too much farther.

At a present price of $20.39, USO, the exchange-traded fund that tracks the price of crude oil, equates to a crude oil price of $53.82 per barrel. This is a drop of 51% from the June 2014 high of $107.68 per barrel, and is the lowest price since 2009.

For a little more perspective, the inflation-adjusted price of crude oil in January 2009, after an 81% crash, was $43.58. If the current slide continued to that point, that could represent a further drop of $53.82 – $43.58 = $10.24 per barrel, which is another 19%. For USO, that would mean a further drop of $3.73, to around $16.66.

Let's say we believe that that is as far as it will probably go, and that even that is unlikely. (Not a recommendation, just saying). And while we're sayin', let's say that we believe that the current oil price wars will be resolved in the next six months, and that oil prices will then eventually return to more normal levels above $75 per barrel, which would be above about $28 for USO.

We also note that at 50%, the implied volatility on USO options is very high, meaning the time value component of these options is extremely expensive. It is at levels not seen since the shocks of the summers of 2010 and 2011. Those levels, in turn, were only exceeded in the massive stock-bond-gold-commodities-real estate meltdown of 2008-9, when implied volatility on oil exceeded 90%. So we know that a further massive crash and expansion of option premiums is not outside the realm of possibility, but we believe (let's say) that the worst damage has been done, and that options are ripe for selling.