Writing covered calls (CC) is a commonly used strategy for increasing income in a stock portfolio. Just to review, a covered call (CC) strategy consists of buying a stock and writing (selling) a call against the stock. Your stock, acts as collateral for the obligation to deliver the stock if the stock price is above the option strike price at expiration. You receive option premium income because you give the right to an option buyer to buy your stock at the strike price.
A basic rule of thumb in writing covered calls (CC) is to choose underlying stocks that you wouldn’t mind holding in case the stock declines. This basic rule would also apply if you were buying a stock for its’ dividend income. In both cases, the highest risk in the position is the decline of the stock, which could create a loss many times larger than the income acquired from the CC or dividend.
Assuming that the stock fundamentals are acceptable to you, the next decision in writing a CC for income is, “What strike price should I write?” The strike price is the key decision that controls the risk/reward for your position. Each strike price in the PowerOptions chain has 4 calculated numbers that illustrate the risk vs. reward you should consider. The 4 calculations based on the option premium you receive are:
- % Downside Protection – the % the stock can decline before you lose money in the CC position
- % if Unchanged – the % return or interest you receive from the premium on the option you wrote, if the stock price does not change
- % if Assigned – the % return or interest you receive from the premium on the option written plus any gain from stock appreciation, if the stock is higher than the strike price when the option expires
- % Probability – the calculated probability or odds that the stock price will be above the Strike Price at option expiration
If we look at a typical option chain for a stock, the following observation can be made in regard to strike price:
- As the strike price increases, the covered call option premium declines
- As the strike price increases, % Downside protection declines
- % if Unchanged is highest for options AT the stock price or at-the-money (ATM)
- % if Assigned increases with higher strike prices, which means the stock, must rise above the strike price to achieve this % return
|Simplified Apple Inc. (AAPL) @ $92.79 chain with 32 days to expiration:|
We’ve covered in a broad sense how strike price would affect the four measures of risk vs. reward, but let us now consider each in the context of a covered call investor. As a covered call investor, you might want to get the highest return possible, but the highest returns come with some conditions that you should be aware of. The highest CC return based on premiums comes if the stock is unchanged in price and you write the strike price that is closest to the present price of the stock. In the example above, the $93 strike price for a return of 2.6% is the highest return if AAPL is unchanged in stock price. At expiration, we get to keep the $2.42 and keep the AAPL stock we own.
However, if AAPL should rise in price we would not benefit from the stock appreciation, because the stock would be called and assigned (sold) for $93. There’s about a 50/50 chance that AAPL will be sold to meet the option contract obligation. An investor seeking the maximum premium must assess if assignment is acceptable or develop a contingency plan, which would generally mean rolling the option up to a higher strike price once the option is ITM.
If the stock were to decline, we keep the premium of $2.42, which helps insure or protect us from the decline. Hopefully the stock decline will not be greater than the premium received, but either way the investor is better off having written the call.
If the investor is very bullish on AAPL, he may want to write the $96 strike price. It pays a smaller premium, but there is the possibility of making some capital appreciation if AAPL should rise in stock price. If AAPL went over $96 the option premium would bring in $1.20 and capital appreciation would bring in $3.00 more and the % if assigned return would be 4.8%. However, there is only a 30% chance that the stock will rise to $96. And if the stock actually declined, there would only be $1.20 of option premium to protect or insure the downside. The downside is only protected from a 1.3% decline in Apple’s stock price. Therefore, the $96 strike price is best suited for the investor that is optimistic about Apple’s stock rise and is willing to sacrifice the premium for the possibility of a stock advance and wants a low probability that AAPL will be assigned (sold).
The last case is the $90 strike price, which is $3 in-the-money (ITM). Who would want to write the lower strike price? Well, if an investor was concerned that the price of AAPL would decline, then the $90 strike price offers the highest premium of $4.20 and has the highest downside protection to protect as much as a 4.5% decline in the price of AAPL stock. This extra protection comes at the cost of a lower % if Assigned and the probability of being assigned is the highest of the 3 strike price alternatives at 66.7%. The lower strike price alternative is best suited for the conservative investor that is concerned about a decline in the stock and may want to liquidate for a little extra premium rather than at the present market price.
In summary we can see that the best strike price is the one that meets your goals, as measured using the 4 calculated returns:
- $90 Strike (ITM) safest with highest % Downside Protection with highest % Probability of assignment with no chance of stock appreciation.
- $93 Strike (ATM) for the highest option income and % if Unchanged with no chance of stock appreciation.
- $96 Strike (OTM) for the increased chance of capital appreciation with the highest % if Assigned and lowest % Probability of assignment.