As you get set to implement your first covered call trade, you face the choice of which call option strike price to go with for the option side of the trade. Covered calls involve buying shares of stock and selling call options against those shares. The money -- called the premium -- you get from selling the calls is income to your account, but it is also possible to set up the trade to make some more money if the stock price increases. The strike price is what you will receive for your shares if the sold calls are exercised by whoever buys them. This concept plus how calls are priced can be combined to make picking the right call option strike price a snap.
Pull up an option chain for a covered call writing prospective stock. Use the quote system of your brokerage account and then select the options chain link. Further narrow your search to call options with an expiration date two to three months in the future.
Make a note of the current share price of the stock and the call option price for a strike price below the current stock price, one close to the stock price and one slightly above the stock price. For example, assume a particular stock has a current share price of $35.74. The 3-month call option with a $34 strike price is quoted at $3.70, the $36 strike call is at $2.70 and the $38 strike option is $1.85.
Plug the stock share price and option strike and premium prices into a covered call calculator. Your online brokerage account will provide the calculator in the options tools section of the website. A very usable calculator is available on the optionseducation.org website. Make sure you enter the correct information for each call option you want to check out.
Analyze the calculator results comparing the expected return if the stock price remains unchanged and if the stock is called away at the strike price. Continuing the example, here are the results for each strike price followed by the return if unchanged and if called: $34 strike price: 6.1 percent, 6.1 percent. $36 strike price: 8.2 percent, 9.0 percent. $38 strike price: 5.5 percent, 12.1 percent.
Select the call option strike price based on where you think the stock price will go between now and the option expiration date. In the example, the lowest strike price does not make much sense unless you think the stock will decline instead of increase. The other two strikes give a choice of more option premium income or more share price gain if the stock does increase in value.
- The popular choice for covered call trades is to pick a strike price above the current share price, providing the potential for some extra gains if the share price does increase.
- The covered call calculator results are for the time period until expiration. If you make 8 percent in three months, that is 32 percent on an annual basis.
- Picking a strike price below the current stock price -- an "in-the-money" call option -- gives more downside protection in exchange for a higher probability that the stock will be called away.
- Writing out-of-the-money call options may result in the stock not being called and you can sell more options on the same shares after the current batch of call options expire.
- One call option contract is for 100 shares of stock. So covered call trades are in multiples of 100 shares with a matching call option for each 100 shares. It also means that a call option quoted at $2.70 costs $270.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.