In challenging market environments, we favor in-the-money strikes for our covered-call trades, explains Alan Ellman of The Blue Collar Investor.

The intrinsic-value component of our option premiums will provide additional downside protection and lower the breakeven price point (BE) below that of at-the-money and out-of-the-money strikes. But which ITM strike should we select? This article will explain the BCI approach to selecting such a strike using Etsy, Inc. (ETSY), a stock in our premium member stock report on 12/28/2020 (ETSY had a significant price decline after the recent earnings report which we all avoided, I hope).

ETSY Bullish Price Chart on 12/28/2020

ETSY: Price Chart Showing Bullish Moving Average Signals
ETSY: Price Chart Showing Bullish Moving Average Signals

ETSY Option Chain on 12/28/2020 for ITM Strikes

ETST Option-Chain for the 1/29/2021 Expiration
ETST Option-Chain for the 1/29/2021 Expiration

  • $170.00 strike: Bid price of $$24.35
  • $175.00 strike: Bid price of $20.80
  • $180.00 strike: Bid price of 17.85

Keys to ITM Strike Selection

First, we must define our initial time-value return goal range. Without that, we could never have a structured approach to strike selection. For me, it’s 2%-4% per month for near-the-money strikes. This applies to both OTM, ATM and ITM strikes. Once we establish the ITM strikes that generate appropriate time-value returns based on our personal goals, we go to the next layer of evaluation:

  • The more defensive we want to be, the closer to 2% we go
  • A moderate defensive position would target a 3% initial time-value return
  • A minimal defensive position would target a 4% initial time-value return

ETSY 1-Month Initial Time-Value Calculations with the Ellman Calculator

ETSY Calculations with the Ellman Calculator
ETSY Calculations with the Ellman Calculator

  • All initial time-value returns meet the 2%-4% stated goals
  • The $170.00 strike offers the greatest downside protection of the initial time-value profit of 10.7%, with a BE of $166.08
  • The $175.00 strike offers the moderate downside protection of the initial time-value profit of 8.1%, with a BE of $169.63
  • The $180.00 strike offers the smallest (but still significant) downside protection of the initial time-value profit of 5.5%, with a BE of $172.58

Discussion

When selecting the best ITM covered-call strike, we must first identify our initial time-value return goal range. Then we go to an option chain and feed that information into the multiple tab of one of the BCI Calculators. The most appropriate strike will align with our stated goal and reflect the degree of protection we are seeking.

Learn more about Alan Ellman on the Blue Collar Investor Website.