This Picking the Best Strike Price for Covered Calls page is a sort of unofficial Part 2 to the more introductory page on covered calls and strike prices.
On that page, we used a real world example and discussed in detail the implications of different strike prices when it came to writing covered calls (in the money, at the money, and out of the money).
See the covered call terminology page for these and other related definitions.
The conclusion I came to was that the best strike price for covered calls really depended on what your objectives were and why you were selling calls in the first place.
So now, let's look in greater detail at 3 strike price strategies for writing covered calls: option income, option investing, and option trading.
Note: These categories may be somewhat of an oversimplification, but they aren't arbitrary. Understanding the principles behind each approach is what's most important.
Probably the most popular covered call approach is writing covered call options for the income.
If you're new to options, this is an excellent strategy to start with in order to to get your feet wet and gain valuable hands-on experience working with options. Not only is the strategy easy to understand, it can also be set up very conservatively.
And it can either be a building block for learning other more advanced strategies, or it's perfectly suitable for a lifelong option trading strategy.
Although there's a lot more you can do with options, never feel that you have to adopt and comprehend more complex and sophisticated option trading strategies in order to make money with options.
The important thing is to match your option trading strategies with your own personality.
But as I've said elsewhere, options are a risk dial, not a risk switch, and any trade can be made to be more conservative or more risky. Just because covered calls can be set up conservatively, doesn't mean that they always are set up conservatively, or that they're ever risk free.
There's much to be said in defense of call writing, but it's also critical that you understand the drawbacks of covered calls. And there are two big ones:
To some traders, these two disadvantages are enough to call into question the very validity of call writing.
Personally, I don't go that far. But I do think it's important for you to really be clear on your objectives. If you're going to write calls strictly for the income, be willing to commit to it and all that it entails.
And a big part of what it entails is accepting that you're going to miss out on those occasional big moves higher.
Of course, during flat or range bound markets, you have the potential of racking up some enviable gains while the stock basically goes nowhere.
So what is the best strike price for covered calls when your primary motivation is income?
The short answer is in the money, and as deep in the money as is practical.
Why? Here are two solid reasons:
Whether you're a long term investor who's looking to occasionally generate additional income from your portfolio, or whether you're an enthusiastic Leveraged Investor like myself who uses options strategically to continually lower the cost basis on my investments, covered calls can sometimes be an attractive strategy.
The trick, however, is to avoid getting assigned and being forced to sell your shares. It's difficult, after all, to be a long term investor if all you end up with are short term positions.
Because you have a different objective than the purely income-oriented call writer, the best strike price for covered calls in your situation is going to be much different than the income investor's.
In the Essential Leveraged Investing Guide, I detail a customized and creative strategy to generate covered call income from your long term holdings while minimizing the chances of being assigned against your will and being forced to sell shares that you, as a long term investor, presumably don't want to sell.
One common sense approach you can easily adopt on your own to lessen the risk of having your shares called away is to simply choose a strike price as far out of the money as is practical.
The farther out of the money you set the strike price, the more "upside" protection you allow yourself. Of course, you don't want to choose a strike price so far out of the money that the premium received barely covers the cost of the commission.
But as a long term investor (or a Leveraged Investor), covered call income is a nice addition to your long term investment returns, not a substitute for them. That means you don't need to make a killing selling calls and you can afford to accept smaller premiums.
And even if you are forced to sell a stock position, at least you'll participate in much more of the capital appreciation than you would have at a lower strike price.
If you already are, or some day aspire to become, a competent practitioner of that dark art, Technical Analysis, then a whole other world of possibilities will open up.
And that means for you, the best strike price for covered calls is going to depend heavily on your own analysis of the underlying stock via its chart.
I call technical analysis a dark art only in jest. In all seriousness, effective technical analysis is both science and art. It's somewhere in between. It's not arbitrary or random - but neither does it fall within the realm of infallible prophecy.
Technical Analysis 101
The two most important things to understand about technical analysis are:
#1 - The Rationale - A stock chart is simply the visual representation of a stock's (or index's) past price action. Of course, it's not the stock itself that creates or causes that price action - it's the aggregate group behavior of other traders and investors.
So although a chart tracks a stock's historical price, what technical analysts are really reading from a chart is the past aggregate group behavior of other traders and investors in the hopes of being able to make an educated guess about the future aggregate group behavior of those other traders and investors.
#2 - The Purpose - In a nutshell, what all the various moving averages and trendlines and endless arcane terminology is really all about is the attempt to determine levels of support and resistance in a stock's share price - and how strong or weak those levels are (i.e. how likely they are to hold).
So imagine then that if, through technical analysis, you gained greater confidence in getting a handle on a stock's likely "behavior" in the near term? Would you ever be 100% certain? Of course not. But if you were reasonably confident of being able to identify the headwinds and tailwinds of a stock, that could be a huge advantage.
For the pure trader then, there is no best strike price for covered calls since, depending on changing situations, that "best strike price for covered calls" may be changing, too.
Here are a couple of hypothetical examples:
Example #1 - Imagine that the stock of the XYZ Zipper company is currently experience a pullback of sorts. Through your close and careful reading of the technicals, however, you've identified a key support level that the stock seems to be working toward.
If the stock continued falling and neared that level, and you thought there was a good chance that the key support level would hold, you could consider writing a covered call either at the money (to maxmimize option premium) or in the money (to give yourself some added protection).
Example #2 - Imagine an opposite scenario where XYZ was in a moderate to strong uptrend. In that situation you might buy the underlying stock and write an out of the money call in order to maximimze returns, or you might even wait a week or two first and give the underlying stock a chance to hit a higher level before you considered writing your call.
As with most option strategies, there are many variations to writing calls. And with all approaches, arguably the most important factor is to make sure your trades align with your own personality.
Resources for Call Writers
Born To Sell (Option Trading) - Buy Stocks - Sell Calls - Earn Income
Leveraged Investing (Option Investing) - Use options to continually reduce your cost basis and accelerate your investments
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: $11,625.47
Tot. Discount: 57.92%
Adj. Div. Yield: 10.18%