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Strike Price Selection- A Critical Covered Call Decision

Covered call writing requires a logical sequence of stock and option decisions. Once we have screened our stocks to locate the greatest performing stocks in the greatest performing industries we must make a decision as to which strike price to use. Our choices include:

  • in-the-money
  • at (near)-the-money
  • out-of-the-money

Let’s look at the options chain for the December contracts which represent a 4-week period expiring on December 16th. This was the options chain after the November contracts expired:

RHT- Options chain for the December contracts

With the current market value @ $49.04, I have selected the following strikes to evaluate (additional strikes can also be viewed):

  • $47 in-the-money (green field) generates $3.60
  • $49 near-the-money (yellow field) generates $2.40
  • $52.50 out-of-the-money (purple field) generates $0.95

Next let’s enter these stats into the “single tab” of the Ellman Calculator:

Ellman Calculator- information entered

Once this information is entered in the blue cells, the results appear in the white cells on the right side of the page:

RHT- Ellman Calculator results

Each strike tells an important story:

$47 (green field):

  • 3.3%, 1-month initial  return
  • 4.2% downside protection of the option profit
  • No upside potential

$49 (yellow field):

  • 4.8%, 1-month initial return
  • Little or no downside protection or upside potential

$52.50 (purple field):

  • 1.9%, 1-month initial return
  • No downside protection of the option profit
  • 7.1% upside potential (possible total of 9%, 1-month return)

What these calculations tell us:

  • The time value or option profit for I-T-M strikes offer lower returns than the near-the-money call but the greatest protection for the option premium
  • A-T-M (near) calls provide the highest ROO (initial premium profit) but little or no upside potential or downside protection of the premium
  • O-T-M calls offer less option profit than the A-T-M calls but the greatest total profit potential should the upside be realized or almost realized.

When to use each strike:

  • I-T-M strikes are the most conservative and easiest to unwind because of their high delta (move down in price nearly dollar-for-dollar with stock price decline). Use these when technicals are mixed and/or the market is bearish or volatile.
  • A-T-M strikes can be used when technicals are good and market conditions are positive.
  • O-T-M strikes are used when extremely bullish on the stock and general market conditions are favorable 

Laddering the strikes:

There is no law that says you must use the same strike when you have multiple contracts. You can use some of each, favoring a particular strike based on the overall environment.

Conclusion:

When it comes to strike selection one size DOESN’T fit all! Evaluate the stock and market parameters and then make a Blue Collar decision that has the best chance to maximize your returns.

Get a Kindle for the Holidays? ALL BCI Books Now Available in Kindle Format:

 Cashing in on Covered Calls:

http://tinyurl.com/cashinginCCs

 Exit Strategies for Covered Call Writing: 

http://tinyurl.com/ccexitstrategies

 Alan Ellman’s Encyclopedia for Covered Call Writing:

http://tinyurl.com/covered-call-encyclopedia

 

Market tone:

The final week of 2011 showed a rising consumer confidence to 64.5 in December, up from an October low of 40.9. This was well above the consensus estimate of 58.3. To get a more substantial boost we would need to see a stronger recovery in the unemployment figures. For the week, the S&P 500 was down 0.6% for a final year-to-date return of 2.0% including dividends. Here are the major index results for 2011 (without dividends):

  • Dow 30- + 5.5%
  • S&P 500- Flat
  • Nasdaq- (-) 1.8%

With just this information it would seem like we had a rather uneventful 2011, kind of quiet. The truth, however, is that the following photos can best describe our stock market for this past year:

2011: A wild ride

 
For a more technical look at the 2011 stock market, here is a chart I constructed that shows the ups and downs of this years challenging market:
 
Up-down-up = flat

 

Strike price selection and exit strategy execution has been particularly critical this year and continues to be so moving forward. Once the market establishes a quieter trading pattern we can move to a more aggressive stance and integrate our out-of-the-money strikes and higher beta equities.

Summary:

IBD: Confirmed uptrend (see above chart)

BCI: Cautiously bullish but hedging positions with ITM strikes and low beta stocks.

 Our thanks to you:

The BCI never dreamed that it would garner the support and following that you made possible. We will never take that for granted. Our goal for 2012 is to work even harder to justify the confidence you have shown us. Look for many positive surprises this year that will make the BCI community better than ever.

Happy New Year,

Alan and the BCI team

 

 

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About Alan Ellman

Alan Ellman loves options trading so much he has written four top selling books on the topic of selling covered calls, one about put-selling and a sixth book about long-term investing. Alan is a national speaker for The Money Show, The Stock Traders Expo and the American Association of Individual Investors. He also writes financial columns for both US and International publications along with his own award-winning blog.. He is a retired dentist, a personal fitness trainer, successful real estate investor, but he is known mostly for his practical and successful stock option strategies.

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21 Responses to “Strike Price Selection- A Critical Covered Call Decision”

  1. Barry B December 31, 2011 5:29 pm #

    Premium Members,

    The Weekly Report for 12-30-11 has been uploaded to the Premium Member website and is available for download.

    Best,

    Barry and The BCI Team

  2. FrankK December 31, 2011 7:42 pm #

    Happy New and thnk you to the BCI team

  3. Don B January 1, 2012 11:32 am #

    Evidently I get to be either the first or one of the first to wish Alan and the whole gang – a very Happy and Prosperous New Year.

    Don B.

  4. Barry B January 1, 2012 12:26 pm #

    DonB and FrankK,

    Thank you so much. A happy, healthy, safe, and prosperous New Year to you and your loved ones…same wishes to all of the Blue Collar community.

    Best,

    Barry

  5. Phil January 1, 2012 12:45 pm #

    I wanted to take a moment at “the end of an inning” to sincerely thank you Alan for the education gained in the past two years from you. Because of the tools learned from your dvd’s and books, I have become confident and successful, up 17 % for 2011.
    I follow your teachings but not as completely as I should. I have made a considerable sum selling aapl calls every month including earnings. I have a 375 and a 400 jan. I will probably buy back the 375 this week pocketing most of the premium and reducing risk going into earnings. That has been great but I did learn a lesson this summer selling a full slate of aug. calls and then going on vacation. I was crushed, you warned us.

    Once again, thank you for all that you do for us, this is real money and more relaxed investing for many grateful followers.
    Phil from ma.

  6. Barbara January 1, 2012 2:58 pm #

    If you sell an in the money option is there any way of capturing more profit if the stock price goes up in value?

    I’d also like to wish the BCI team and all members a happy, healthy and prosperous New Year.

    Barbara

  7. Fred January 1, 2012 4:20 pm #

    Alan,

    Any thoughts on the so-called January Effect and whet5her you are considering this in your decisions? Thanks and happy new year to you and your team.

    Fred

  8. admin January 1, 2012 5:40 pm #

    Barbara (#6),

    Yes, there may be an opportunity to generate even more cash in your scenario. On first look, it appears that when an ITM call is sold there is no chance of additional profit from upside share appreciation. HOWEVER, when a stock moves further and further above the strike, the time value of the option premium approaches zero. This means that we can unwind our total cc position at virtually no cost to us as the option trades near “parity”. Let’s say we sold a $30 call and the stock is trading at $40. That call will be trading near $10. If we buy back the option @ $10 and sell our shares @ $40 instead of $30, our position is closed at no cost to us. We can then take the cash to enter a new cc position in the SAME month with the SAME cash…2 income streams in the same month using the same cash…beautiful. Check pages 264-271 of my new book for more details on how this works.

    Alan

    • Michael February 1, 2016 12:51 am #

      hi Alan,

      in your reply to Barbara, you said that “the option trades near parity”. can you explain what you mean?

      thanks, Michael

      • Alan Ellman February 1, 2016 6:46 am #

        Michael,

        An option premium consists of intrinsic value (amount the strike is in-the-money) + time value (additional premium above intrinsic value, if any). If an option trades at intrinsic value only, it is said to “trade at parity”

        For example, if a stock is trading at $60.00 and the $50.00 call option trades for $10.00, it is trading at parity…all intrinsic value and no time value.

        Alan

  9. admin January 1, 2012 5:43 pm #

    I’d like to also thank our members for your generous on and off site New Years wishes to our team. We are humbled by your kindness and support.

    Alan

  10. Mark January 1, 2012 9:11 pm #

    Hi Alan,

    On your response to Barbara you said to buy back the call and sell the shares, then you could start a new cc position. My question is why would you sell the shares? Why not keep the shares and just sell another call, such as the $40 call?

  11. admin January 2, 2012 5:54 am #

    Fred (#7),

    Historically, January has been a bullish month for the market as investors who sold stock losers at the end of the previous year for tax purposes are re-entering the market. This “effect” has been less pronounced lately because of the large number of investors trading in sheltered accounts. I also believe that issues in the Eurozone will have a greater impact on the stock market (positive or negative) than the January Effect.

    Alan

  12. admin January 2, 2012 7:55 am #

    Mark (#10),

    I generally do not roll up in the same contract period especially after an exponential rise in share price as Barbara desribed in her question. Let’s say we buy back the $30 call for $10 and sell the $40 call for a 2.5% return or $1. My concern is a drop in share price after that large increase due to profit-taking. If the price drops by more than $1 we start losing money. In the example I give in my book, we generate a 2.2% ADDITIONAL income stream which is protected by 3.7% since the new option sold was an ITM strike. In this way, we generate a nice second return for the same cash in the same month and retain a low-risk approach.

    Alan

  13. admin January 2, 2012 5:18 pm #

    Covered Call Writing- Barrons article:

    http://online.barrons.com/article/SB50001424052748703805304577124633341696956.html?mod=undefined

    The BCI team

  14. Todd January 3, 2012 6:37 am #

    What is the significance of the comment “chart < 1 year" by GNC on the recent stock list?

    Todd (new member)

  15. Barry B January 3, 2012 9:01 am #

    Todd (#14),

    Ideally,when we look at a stock chart we want to see at least one year of stock performance. In the case of GNC, it went public recently and does not have a full year of price history. We identify that fact so you can make a more informed decision as to whether you want to trade GNC.

    Best,

    Barry

  16. Edward January 3, 2012 6:50 pm #

    Can anyone suggest a free site that shows historical options data? Thanks for any assistance.

    Ed

  17. Barry B January 3, 2012 8:05 pm #

    ED (#16),

    You can to to Think Or Swim (TOS) and set up a free “Paper Money” virtual account. You can use their “Think Back” feature and get end of day data.

    Best,

    Barry

  18. Amy January 4, 2012 4:18 am #

    Ed,

    Here’s another.

    •Go to http://www.dailyfinance.com

    •Enter the stock symbol for quotes

    •On the left of the quote page you will see a hyperlink “option chain”

    •When you see the option list, each of the options will be a hyper link

    •If you click on the option symbol a small window will pop up with details, including a graph

    Good luck.

    Amy

  19. Jean January 4, 2012 1:15 pm #

    Alan,

    On page 111 of your newest book you discuss ‘laddering” strike prices.
    Is there a formula you use to determine the percentage of each strike type in different market conditions like 80% OTM in bull markets?

    Thanks.

    Jean

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