How to Find the Best Covered Call Strike Price
Sep 09, 2023For even more about how to find the best covered call strike price, check out the video below.
Covering the topic of how to find the best covered call strike price is essential because it’s probably the most common question we receive from students embarking on their options trading journey.
Theoretically speaking, the perfect strike price is the one where the underlying asset will be At-the-Money (ATM) at option expiry.
Of course, the odds of that happening are incredibly slim.
In the real world, there is no perfect covered call strike price because no one knows what the underlying asset will do.
Choosing the best covered call strike price is really all about bias, market outlook and the objectives of income and growth.
In the case of stock options, there is further consideration of whether or not a trader wants or is willing to sell their stock due to the probability of assignment.
Ultimately, the choice of strike price will significantly impact the risk-reward dynamics of the strategy.
In this article, we will discuss the various considerations for choosing the best covered call strike price and expiration, plus delve into the associated risk-reward considerations.
Understanding Covered Calls
Before tackling strike price selection, let’s briefly review the basic mechanics of a covered call strategy. A covered call involves two main components:
Long Underlying Position:
A trader or investor holds a certain number of shares or a specific amount of other underlying asset such as a cryptocurrency that has options trading against it.
This position provides potential capital appreciation, and in the case of stocks, potential dividends.
Short Call Option:
Simultaneously, the trader or investor sells a call option (or options) on the same underlying asset. This obligates the trader or investor to sell the underlying asset at a predetermined strike price (if the option is exercised) within a specified time frame (expiration date).
Note that some options such as cryptocurrency and index options are cash-settled, where there is no obligation to sell the underlying.
So in the case of cash settlement, if the underlying asset’s market price was higher than the strike price at expiration, the difference between the two prices would be cash settled (deducted from the call options seller account and credited to the call buyer account).
Further to that, it should also be noted that the covered call seller can buy back the sold (short) call at any time prior to expiry, thereby avoiding any assignment or settlement altogether.
Time and Price
The two primary considerations when choosing the best covered call strike price revolve around time and price.
Time:
When selling covered calls, time refers to the expiration date of the short option. A trader or investor wants to select an expiration date that matches their market outlook and maximize the premium received.
If selling short-dated options such as 2 weeks or 1 month into the future, the premium received will be much less than with an option that expires in say, 3 months or more because there’s more time value present and a higher chance that the option will expire In-the-Money (ITM). This consideration must be balanced.
So why not sell an option far out in the future and receive a very high premium?
Of course, this is done, but it’s certainly not something we at Rogue Trader Academy do very often for the simple reason that there is very little time decay in long-dated options.
For this reason, we tend to sell options that expire in 60 days or less, taking advantage of accelerated time value decay. Remember, as option sellers, we want to sell high and buy low (or let the option expire worthless).
Plus, there’s a flexibility factor. If we sell a 6-month or even longer-dated option, a lot can happen during that period of time, especially in the cryptocurrency markets.
Price:
Choosing the strike price, as with choosing an expiration date, is also correlated to a trader's or investor's market outlook and whether or not they want to continue owning the underlying asset.
The price selection strategies below help clarify this decision-making process.
Strategies for Choosing the Best Covered Call Strike Price
Choosing the best covered call strike price is a strategic decision that hinges on the trader or investor's bias and outlook for the underlying asset and possibly overall market conditions.
Here are the basic strategies for selecting strike prices:
Out-of-the-Money (OTM) Strike:
An OTM strike price is above the current market price of the underlying asset. Most covered call campaigns are executed with an OTM strike.
The distance of how far OTM the strike price is from the current market price of the underlying is the primary factor. The father OTM, the less premium received because there’s less chance of that option expiring ITM.
An OTM-covered call is a bullish strategy, and one where the trader or investor typically wants to hold onto the underlying asset.
By selling an OTM call, there’s room for the underlying asset to appreciate in price, while at the same time collecting income in the form of premium from the sale of the call option.
The idea here is that one would want to try and choose the price within the given time frame where we think the underlying asset could rise.
If the underlying asset rises above the strike price, there is the risk of assignment (with stocks) and having the underlying shares called away.
Of course, there are plenty of ways to avoid this by adjusting the covered call prior to expiry or as the underlying asset’s price approaches the strike price.
At-the-Money (ATM) Strike:
An ATM strike price is close to the current market price of the underlying asset. This strategy is one where the trader or investor has a neutral outlook on the underlying asset and expects the price to remain stable.
Selling an ATM covered call is often done in a shorter time frame where the underlying has entered a channel or trading range or after a significant move up and is expected to “rest” or slightly decline in the short term.
While the odds of assignment are greater and there would be no realized value if the price of the underlying asset rises, the premium collected is much greater than that of an OTM option.
This greater premium received also reduces the cost basis of the underlying and provides some downside protection.
In-the-Money (ITM) Strike:
An ITM strike price is below the current market price of the underlying asset. This strategy generally suits those who are slightly bearish on the outlook of the underlying.
Selling an ITM call generates the highest option premium because it has intrinsic value as well as extrinsic (time) value. This provides even greater downside protection in the event the underlying asset price declines.
However, there’s a higher probability of the option being exercised (for options that are not cash settled), potentially resulting in the trader or investor selling their asset at a lower price than the market value at expiry.
Risk-Reward Considerations:
The choice of strike price, along with expiration in a covered call strategy directly impacts the risk-reward profile of the trade.
Out-of-the-Money Strike:
Reward:
The potential reward in an OTM strategy comes from both the premium received and the potential for the underlying asset to appreciate in price up to, but not beyond the strike price.
If the underlying asset’s price remains below the strike price at expiration, the option will expire worthless and the trader or investor will keep 100% of the premium as profit.
Risk:
The main risk in an OTM strategy is that the underlying asset’s price will decline sharply. The premium received from selling an OTM call option provides little downside protection and may not offset the loss in value of the underlying.
Many new traders think that the main risk of an OTM strategy (or any covered call strategy) is if the underlying asset sharply increases above the strike price. This is not a risk in the sense that one is not "losing" money. Rather, it’s a matter of missing out on the opportunity to participate in the increased value of the underlying asset beyond the strike price.
At-the-Money Strike:
Reward:
The primary reward in an ATM strategy comes from the premium received for selling the call option, which would be more than selling an OTM call option. The additional premium received provides more downside protection than that of an OTM option.
Risk:
The risk here too is if the underlying asset’s price declines beyond the protection provided by the premium. There is also very little, if any room to participate and profit from a rise in the underlying asset.
In-the-Money Strike:
Reward:
The rewards from an ITM strategy come from a hefty premium (vs ATM or OTM) received from selling the call option.
Risk:
The risk in an ITM strategy is the same as with the other strategies in terms of the underlying asset’s price declining and of course, there would be no ability to participate and profit from a rise in the value of the underlying. The risk of exercise and assignment is the highest with an ITM strategy, which is why this strategy is often used by those who want to sell the underlying asset.
Balancing Risk and Reward
Choosing the best covered call strike price is about finding the right balance between risk and reward that aligns with your goals and market outlook.
It’s important to note that each strategy has its nuances, and market conditions play a role in their outcomes. A clear understanding of the underlying asset’s potential movements implied volatility, risk tolerance, and desired profit is essential when choosing a strike price.
Conclusion
Choosing the best covered call strike price along with selecting the correct expiry, is a pivotal decision in executing a covered call strategy. Whether you choose an out-of-the-money, at-the-money, or in-the-money strike, understanding the associated risk-reward profile is crucial.
The right strategy will depend on your outlook, risk appetite, and financial goals.