The Right Strike Price for a Covered Call

04/09/2013 1:00 pm EST

Focus: OPTIONS

Mike Scanlin

CEO, BornToSell.com

The answer depends on a few factors. Mike Scanlin goes through a few questions traders should ask themselves before they write a covered call.

One of the most common questions that option traders, specifically covered call traders, ask is, "What expiration should I be selling, and what strike price should I be selling?"  My guest today is Mike Scanlin to talk about that.  So, Mike, give us your lesson on how to choose a strike price and expiration.

Sure, so on the expiration date, it's always better to sell the near-term option or a series of short-term options rather than one longer term option, because some of the short-term premiums will be larger than a single long-term premium. 

However, you have to consider transaction costs, and the short-term options, if they're only worth a nickel or a dime, are probably not worth selling because of the transaction costs, so you have to go out longer in those cases to get enough premium to cover your transaction costs.  On the question of strike price, the at-the-money options always pay the best.  They have the most time premium possible. 

The in-the-money and out-of-the-money options have similar time premiums, but the in-the-money obviously has more down side protection built into it, and the out-of-the-money has some up side potential built into it.  So, it needs to reflect your bullishness or bearishness on the individual stock.  If you think it's going to go up by the expiration date, you'd probably want to sell an out-of-the-money option.  If the market conditions are such that you're nervous about that stock or the market, you might want to sell an in-the-money strike to help protect your down side.

When I'm looking at an option chain, you know, the closer I get to in-the-money, the more juicy those premiums are, and I start to think, "Hmm, I think maybe I'll get a little bit closer because I'm going to make a little bit more."  That greed factor starts to get into there.  Where do I find that balance?

Well, it depends if you want to lose the stock or not.  If you've owned the stock for a long time and it's in a taxable account and you have a low basis, you may not want to have that stock called away for tax reasons, so in that situation you want to be real careful and write a little bit out-of-the-money more than the in-the-monies. 

If it's in an IRA or if it's just something you don't care about the tax consequences, you're right.  To collect the most time premium, the at-the-monies have the highest premium.  So, it's a tradeoff between capital appreciation and time premium, and some investors like to know they made money on the underlying stock, and some people just like to know they're capturing as much time premium as possible, so they sell at-the-monies.

So, for every transaction you do, you've just got to look at all those factors and kind of make a decision each time.

That's right.  It varies.

What about if you've got a thousand shares, doing 500 shares covered at one strike price and another at another strike price?

That's common, and a good idea.  I mean, you're always going to be half right and half wrong, but at least you're not 100% wrong, you know, which makes a lot of people feel more comfortable.  So that's not a bad strategy to spread it around.

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