While covered calls are considered a basic option strategy, Allan Ellman explains what one should consider when picking a strike price for a covered call strategy.
TIM: My guest today is Alan Ellman from The Blue Collar Investor.com and we are talking about using covered calls and what strike price are you supposed to choose so, Alan, covered calls are a relatively straightforward strategy but choosing the strike price can get a little complicated.
ALAN ELLMAN: Well, yes. The strike price you select should be really based on how bullish you are on the overall market, the particular stock that you are dealing with, and really, your own personal risk tolerance. For example, if you are very bullish on the market, you are going to want to take advantage of that by selling it out of the money strike, so let me set up an example here. You buy a stock for $28, you sell the $30 call for a dollar, so initially, you are generating about a 3% one-month return. Now, if share appreciation goes to the strike of $30, now you have generated an additional $2 for a total of $3, so you can get two income streams by selling an out- of-the-money strike, one from the option sale and the second one from share appreciation, but you want to do that under bullish market conditions.
TIM: For myself, whenever I have tried to do this, it is hard not to get a little greedy and choose the one that is going to give me the most premium and yet, I am probably insuring that I am going to get filled in if I do that, right?
ALAN ELLMAN: Well, the one that is going to give you the most premium all the time is the at-the-money strike, so you buy a stock for $30 and sell the $30 call. That will give you the most premium. However, it will not give you an opportunity for share appreciation because if you buy a stock at $30 and agree to sell it for $30, it can go to the moon and you still have to sell it for $30. Now, the in-the-money strike is the least used of all the strike prices so you buy a stock for $32 and agree to sell it for $30 and you will get a premium of $3. Now, that $3 is not profit because you figure you are going to lose $2 on the sale of the stock, buy at $32, sell at $30, so the actual profit, it is called time value, is $1. You are generating a 3% one-month return but if the stock goes higher, you are not going to participate in that. However, if the stock goes down from $32 to $31 to $30, you are still guaranteed that 3% one-month return so in essence, when you sell an in-the-month strike, you are generating an option profit and you are getting an insurance policy on that profit and the insurance policy, Tim, is not paid for by us, it is paid for by the option buyer. The advantage of the in-the-month strike is that insurance policy so, in essence, intrinsic value is protecting the time value.
TIM: Is there anything about the Greeks that I need to know about helping me decide which strike price or is it just a matter of deciding what is the best premium that I want?
ALAN ELLMAN: Well, the Greeks are important to know, not in terms of the specific Greeks but, for example, if you are bearish on the market, you are going to want to select an option that has a low implied volatility, Vega, so if you go for let’s say an at-the-money strike that is returning 8%, that means the market is anticipating a big move in the price of that stock by expiration and it really doesn’t dictate which direction. If you are bearish on the market, you are going to want to select an in-the-month strike with a relatively low implied volatility, so it does play a role. Faida also plays a role in that you are going to want to sell your option early in the one-month contract because time value erodes not linearly but logarithmically, so a little bit the first week, a little bit more the second week and then, boom, it falls off a cliff.
TIM: You have some great information about this on your website. Tell us what it is.
ALAN ELLMAN: thebluecollarinvestor.com, a lot of free information there, a beginner’s tutorial, lots of blogs, so have your viewers look in on that and they will get plenty of information.
TIM: Thanks, Alan, for your time.
ALAN ELLMAN: My pleasure.
TIM: You are watching the MoneyShow.com video network.
