Picking the Best Strike Price for Covered Calls

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).

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.

Best Strike Price for Covered Calls - Income

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.

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:

• Big Drops - Writing covered calls provides downside protection . . . to an extent. In general, writing them out of the money provides virtually no downside protection, and at the money only provides some. Even writing them in the money (the deeper the better) won't provide much protection if the stock really takes a big tumble.
• Big Pops - This can be maddening. Imagine setting up a covered call trade so that you're anticipating a nice 2-3% return in the next 30-45 days. And then, before you know it, the stock jumps 15%. The good news is you'll still get your 2-3%. But the bad news is you end up missing out on all those other gains.

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:

• You can still generate very good income from writing calls (deep) in the money, so long as the implied volatility levels are such that decent premium is available. And you'll know beforehand exactly what your maximum returns will be. If, after you've done your due dilligence, those terms are acceptable, then pull the trigger and don't look back.
• The more downside protection the better. It's better to leave money on the table than to have to leave the table because you've lost all your money. OK - you're probably not ever going to lose all your money writing calls. But one of the most important tenets of long term success in the stock market is managing risk and limiting your downside.

Best Strike Price for Covered Calls - Investing

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.

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.

Best Strike Price for Covered Calls - Trading

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.

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.

Related: - When is the Best Time to Write Covered Calls?

Best Strike Price for Covered Calls - Conclusion

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.

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