For most call writers, the natural desire will be to maximize their option income, at least in terms of selecting the expiration date that helps achieve this. And with all else being equal, that means selecting an option with the nearest expiration date.
Here's why . . .
One factor that's critical to understand is an option's time decay, also known as theta.
Obviously, the closer an option gets to expiration, the less time value it has. But what's critical to understand is that the rate of time decay actually accelerates as expiration nears.
And the inverse is also important - the farther away an option is from expiration, the slower its rate of time decay.
See the covered call terminology page for related definitions.
So why is this so important when considering expiration dates for covered calls?
There are other factors to consider (addressed below), but if you're looking to maximize your option income, your best choice will most often be to choose near term expiration dates, say one to two months out.
That's because your annualized returns will be highest with calls expiring the earliest.
Although your total return will be higher when writing a covered call with an expiration date farther out, keep in mind that it will take longer to achieve that return.
With a shorter dated option, your returns cover a shorter holding period, so even though these total returns will be less, they're actually higher on an annualized basis.
Let's look at a real world example:
Intraday on 1/18/2011 NKE is trading at 84.10/share. So let's look at the bids on all the available call options at the $85 strike price (and I'm also going to include a $10 commission since that can be a factor, especially if you're writing a single call that's set to expire in just a few days):
How to Calculate Covered Call Option Premium on an Annualized Basis
When I calculate my covered call income on an annualized percentage basis, I take the total premium received and divide it by the cost of my shares and then annualize that return.
[And if I've written the call in the money, I'll take the extrinsic or time value of the option and divide it by selling or strike price.]
The basic formula looks like this:
(Premium Received/Cost of Shares) * (365/Days Until Expiration)
In the example above, I calculated based on an $8420 cost to acquire 100 shares ($84.10/share + $10 commission) and then reduced the premium received by another $10 to cover the hypothetical commission for selling the call.
(And incidentally, that's why the annualized rate on the first expiration month was 22% rather than 32% - one-third of the premium went to cover the commission. The more calls you write at the same strike, the less role the commission plays but be sure to always factor in commissions when you're considering a trade because they really can skew your results.)
There are other valid reasons why you might consider the best expiration date for covered calls to be a date farther out:
KO - 125 shares
KMI - 100 shares
BP - 100 shares
MCD - 30 shares
JNJ - 25 shares
GIS - 25 shares
PAYX - 25 shares
Open Market Purchase Price: $20,071.83
Less Booked Option Income: $16,341.71
Tot. Discount: 81.42%
Adj. Div. Yield: 19.59%