We must master strike price selection to maximize our covered call writing returns. In our BCI methodology, strike price selection is ultimately determined after our careful stock screening analysis and overall market assessment. By developing a watchlist of eligible candidates with elite fundamentals and strong price chart technicals along with passing our common sense screens (like minimum trading volume) we are off to a great start in constructing our monthly covered call writing portfolios. Next we make our overall market assessment (bullish vs. bearish) and that will dictate the percentage of in-the-money (ITM- conservative) and out-of-the-money (OTM- bullish) strikes we will select.
Whether we are favoring ITM or OTM strikes we may have several choices to choose from. So the question now becomes which specific strike price should we select? At this point the calculations become a key factor. The first consideration is to decide what your initial 1-month goals are for your positions (mine are 2-4%). From there, we look at the amount of upside potential if bullish or the amount of downside protection of the option profit if bearish or have a low-risk tolerance. Let’s make some generalizations:
- The more bullish we are, the further OTM we will go after meeting our initial goals
- The more bearish we are, the further ITM we will go after meeting our initial goals
Let’s look at a real life example, using EDU, a stock on our Premium watch List at the time I wrote this article. Below is a 1-month options chain:
Note the following:
- EDU is trading @ $33.68
- We will evaluate ITM strikes of $32 and $33 (yellow fields)
- We will evaluate OTM strikes of $34 and $35 (pink fields)
- We will use the published “bid” prices with the understanding that we can frequently negotiate better sale prices
Next, let’s take these stats and enter them into the Ellman Calculator (for a free copy, use the “free resources” link at the top of this page):
Note the following:
- All initial returns meet the goal of 2-4%
- The more bearish or conservative an investor is, the more likely he (she) is to select the $32 strike and sacrifice some initial return for more protection
- The more bullish an investor is, the more likely he (she) is to select the $35 strike to create an opportunity for greater upside and a potential 7%, 1-month return (3.1% + 3.9%).
The key takeaway here is that there is no one strike price that is best suited for every investor. The factors that need to be considered are:
- Overall market assessment
- Personal risk tolerance
- Individual monthly goals
By factoring in these considerations we will be able to make an appropriate decision for ourselves based on sound fundamental, technical and common sense principles.
Live seminars this week:
Florida seminars in March:
This week there were only a few economic reports to evaluate and the severe weather conditions throughout the country may have influenced the negative tone of these reports:
- Janet Yellen, the new Federal Reserve Chairwoman, testified, for the first time since replacing Ben Bernanke, before the House Financial Services Committee. She will continue to wind down the Fed’s bond-buying program unless the economic recovery takes a negative turn
- Industrial production (a measure of the changes in quantity of physical materials and items produced in the manufacturing, mining, and utilities industries. It is an indicator of trends in the industrial sector) declined by 0.3% in January compared to the 0.3% increase expected by analysts. This was the first decrease since July
- Manufacturing growth for the 4th quarter, 2013 came in @ 4.6%, less than the Fed estimate of 6.2%
- Retail sales (a report of the dollar value of sales of a broad range of goods, from cars and gasoline to furniture, food services, and clothing. Retail sales are a major indicator of consumer spending trends, accounting for a substantial portion of total consumer spending and aggregate economic activity) fell by 0.4% in January while experts were expecting no change from the previous month
- Business inventories (a report of the dollar value of product inventories held by manufacturers, wholesalers, and retailers. Included in the report is the inventories/sales ratio, a gauge of the number of months it would take to deplete existing inventories at the current rate of sales, which is an important indicator of the near-term direction of production activity) increased by 0.5% in December as predicted by analysts
For the week, the S&P 500 rose by2.4% despite the weak economic news.
IBD: Confirmed uptrend
BCI: This site continues to be moderately bullish on the overall economy and feels that the recent weak reports have been impacted by the extreme weather conditions we have experienced. As a result, we are favoring out-of-the-money strikes 3-to-2.
My team and I continue to appreciate your incredible support and thank you for all the positive feedback.
My best to all,