Covered Calls: Which Strike Price to Sell

06/27/2012 7:00 am EST

Focus: OPTIONS

Alan Ellman

President, The Blue Collar Investor Corp.

Out-of-the-money (OTM) options can produce outsized returns when used correctly, writes Alan Ellman of The Blue Collar Investor, reviewing conditions where its best to select OTM strikes for bullish covered call positions.

Whenever a study is performed on covered call writing, a stock is selected and the nearest out-of-the-money (OTM) strike price is sold. This is repeated over and over and then the results are compared to the overall market performance. The usual conclusion is that covered call writing slightly outperforms the overall market, but with much less volatility.

What too many analysts overlook is the fact that the OTM strike has its advantages and disadvantages, and to use it to our greatest advantage, we must explore and understand the circumstances as to when to use this strike and when to avoid it.

An out-of-the-money strike is one where the option’s agreed upon sales price (of the equity) is higher than the current market value of the stock. If we buy a stock for $28 and sell the $30 call option, that strike price is out of the money (OTM).

When to Use OTM Strikes

Consider this strike the most bullish of our covered call positions. The greatest benefit will come if the stock appreciates in value from the time of purchase to expiration Friday. The closer it comes to the strike price (or surpasses it), the more money we realize, and the returns can be eye-popping!

So let’s take a common-sense look at some of the factors that would encourage us to favor this strike price:

  • A bullish overall market with low volatility
  • The stock chart of the equity is technically sound
  • The positive technical indicators are all on high volume
  • The positive momentum is continuous and not the result of a quick spike which could snap back
  • The stock’s industry is also technically strong

Advantages of the OTM Strike

  1. We can benefit from both the option premium and the stock appreciation. One-month returns can easily end up between 10%-20% if the strike price is reached.
  2. Less chance of assignment if we prefer to hold the stock.
  3. Time decay works in our favor since the premium consists only of time value. This means that as we approach expiration Friday, if the strike is still OTM, the time value will approach zero.

Disadvantages of the OTM Strike

  1. This strike offers the least amount of downside protection of the overall position (breakeven) and no protection of the option premium
  2. May be a poor choice for those with low risk tolerance
  3. The initial option premium is low, so the one-month return may not be impressive if the stock does not appreciate in value
  4. This strike has a low Delta. If the stock drops in value, the corresponding option will not change as much, thereby making it more expensive to buy back the option for an exit strategy. In-the-money strikes have the highest Deltas.

OTM strikes have an important place in our portfolios. Those with greater risk tolerance will tend to use them more than those with less. No matter who is writing these calls, they must be used to our greatest advantage.

Select the strongest stocks in the strongest industries that have been uptrending with low implied volatility (avoid violent whipsaws on the charts).

When constructing your portfolio for the month, you can mix, or ladder your strikes, using a higher percentage of these OTM strikes the more bullish you are on the market and decreasing that percentage if you turn bearish. By doing so, we are not under restriction of a call option obligation.

By Alan Ellman of The Blue Collar Investor

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