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When Trading Options, Which Strike Should I Write?

Filed Under Beginner Options Trading 

When Trading Options, Which Strike Should I Write?
One of the first questions new traders have is which strike they should write. There really is no correct answer although, upon reflection, some strikes will certainly sound better to you than others. If you remember the covered call is a premium collection strategy it makes sense to sell an option that is rich in time premium; hopefully you remember that is the at-the-money strike. It would also make sense to sell a relatively short-term option, say 30 days to expiration or so since these options are hit hardest by time decay. By selling a short-term, at-the-money option, you have a mathematical advantage by bringing in a relatively large premium that will quickly lose its value, which is good for you as the covered call writer.
 
However, different investors have different objectives and every strategy comes with a unique set of risks and rewards so we can’t really say that selling the at-the-money option is “the best.” It’s just that it has a lot of nice characteristics but there are always tradeoffs.
 
Which strike to write boils down to different philosophies of why you’re writing the calls in the first place. Because options are classified as out-of-the-money, at-the-money, and in-the-money then those are the different scenarios we can create with covered calls. Each comes with its own philosophy and sets of risks and rewards so let’s look at each in detail.
 
 
Writing Out-of-the-Money Calls
One of the most common approaches is to write calls against your long stock position but with the intent of never losing the shares. These investors usually write short-term, out-of-the-money (higher strike) calls. Investors who write out-of-the-money calls are really hoping the stock will rise to the strike price (or very close) but still leave the call out-of-the-money at expiration. In the AGIX example presented earlier, we assumed the investor wrote the $20 call for $4.40. This investor would ideally want the stock to rise to $20. If the stock’s price does not exceed $20 at expiration, there is no reason for the long call holder to exercise the call since they could just pay $20 in the open market. The $20 call expires worthless but the covered call writer enjoys the price appreciation of the shares plus the premium received from the sale of the call yet is never forced to sell the shares. Avid covered call writers with this philosophy hope this situation happens time after time so they can write new calls when the current call expires while continuing to hang on to the shares. The sale of many call options can greatly enhance the returns that you may otherwise receive from holding onto the shares alone. In fact, if you successfully write calls month after month, you may even write your shares into a negative cost basis.
 
For example, assume an investor buys the stock at $18.81 and writes the $20 call for $4.40. Let’s assume the stock rises during this time very close to $20 at expiration. Because the stock price doesn’t exceed $20, the call will expire worthless and the investor keeps his shares and can write another call the following month. With the stock near $20, perhaps the investor will write a one-month, $22.50 call. The price received obviously depends on the price the market is placing on that call at the time. But let’s say it is trading for $4. If the investor writes this call, the cost basis for the stock falls by another $4 to $14.41 - $4 = $10.41. The investor then hopes the stock will rise but close near $22.50 at expiration. At that time, the investor may write a $25 strike for $4 thus making his cost basis $6.41 and so on. Of course, hoping a stock will behave this well for sustained periods is an unrealistic expectation but the covered call strategy will still work even under less favorable assumptions. We’re just saying this is the ideal situation for those investors who choose to write out-of-the-money calls.
 
The covered call strategy would also work with the stock price remaining the same. In the previous example, we had written the cost basis down to $6.41 with the stock price near $22.50 at expiration. Obviously, there’s nothing wrong with this cost basis if the stock’s price had remained at $18.81.
 
Investors who never want to lose their shares tend to write out-of-the-money call options. They are willing to take a small chance for the stock’s price to exceed the strike in exchange for collecting monthly premiums.
 
The problem with the philosophy of writing covered calls with the intent of never losing the stock is that you are really acting like a “naked” call writer even though you also happen to own the underlying stock. A naked call writer, as we said earlier, is one who writes calls but does not own the underlying shares. This is a high-risk strategy since there is no limit as to how high the shares may be trading if you are forced to deliver them. Naked call writers definitely do not want the stock to rise. If you are writing call options against your stock but do not want to lose the shares, then you are acting like a naked call writer. Because of this, you will tend to write short-term, out-of-the-money calls to reduce the chance you’ll lose your shares. But when you write short-term, out-of-the-money calls, you will usually not bring in much premium either (since higher strike calls are cheaper), but you still have the potential obligation to sell your stock.
 
Because there’s not much time premium involved, you will not have a lot of downside protection either. Writing out-of-the-money calls can yield very high returns but most of those returns are due to stock price movement and not from the sale of the option. So for many investors, writing out-of-the-money calls doesn’t make a lot of sense no matter how small the chance of getting assigned (“called out”) may seem.
 
 
Writing At-the-Money Calls
If there were such a thing as a textbook definition of a covered call, it would probably be defined as one where the investor writes the front month, at-the-money call. Remember, the idea behind the covered call is to collect a relatively large premium from an option that will quickly decay in value. The strike that carries the most time value and sharpest decay is the at-the-money strike. Investors who write at-the-money calls collect the highest amount of time premium and also create a lower cost basis on the stock, which provides a little bigger downside hedge.
 
Investors who write at-the-money calls will not have the room for capital appreciation like out-of-the-money call writers. However, at-the-money calls provide a little more downside protection so they are less risky.
 
 
Risk of Covered Calls
As Figure 6-2 showed, the covered call writer is exposed to all of the downside risk of the stock (less the premium received from the option). The one thing you don’t want to have happen as a covered call writer is for the stock’s price to fall below the cost basis. This also corresponds to why we said that covered call writers should have a neutral to slightly bullish outlook. You do not want to write a call if you think the stock is going to crash. However, many new investors believe that you should write calls against stocks that you think are about to fall. You must remember when combining assets in a portfolio (such as shares of stock plus short calls) that it is the overall behavior of all assets that counts. When new investors learn about options, they learn that selling a call is bearish so they immediately infer that the covered call strategy is bearish since they are selling a call. But this ignores the fact that the covered call writer is also long the stock. In Chapter Two, Pricing Principle #5 showed us that the maximum price for a call option is the price of the stock. This shows that the call option will always be worth less than the stock. So if you own the shares and write the calls, you are holding an asset (stock) that is far more valuable than the calls. The last thing you want is for the price of that asset to drop significantly even if that action may be beneficial for the lesser-valued option.
 
Obvious as this may seem, there are many “professional” brokers of financial planners who will emphatically tell you that the risk of the covered call is that you give up potential price appreciation. In fact, here are three samples found on three different financial sites on the Internet:
 
·         Since the short call is covered by the portfolio, this strategy has no downside risk. The only upside risk is that you give up the price appreciation above the strike price of the call; however, the call premium paid at the outset may compensate for this risk.
 
·         While the covered call writer has no risk of losing huge amounts of money, there is an attendant risk of missing out on large gains. This is pretty simple: if a stock has a large run-up in price, and calls are nearing expiration with a strike price that is even slightly in the money, those calls will be exercised before they expire, i.e., the covered call writer will be forced to deliver shares (known as having the shares “called away”).
 
·         Writing covered calls (i.e., call options over stock that you own) is perhaps the safest of all options strategies and possesses minimal risk. The aim is to generate income through premiums with the potential to collect capital gains as well, should the share price remain below the exercise price.
 
You can see that the suggestion or tone of many “professionals” is that covered calls are essentially risk-free. In fact, the first and second examples state that the risk is that you miss out on large gains. As we said before, the risk of any financial asset is never defined as missing out on some reward, and you must question the judgment of anyone who tells you that it is. If that were true, then the risk of buying Microsoft at $30 is that you might sell it later for $35 only to see it trading higher. Missing out on potential gains is always a regrettable possibility with any asset – but it is not the risk. To combat the downside risk of the covered call, many investors write in-the-money calls and there are many benefits to considering this often-overlooked variation.
 

The risk of the covered call is that the stock price falls. The risk is not getting assigned on the short call and selling below market price. That is a missed opportunity and risk is never defined as missing out on some reward.

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