Where can you find good option writing candidates?
There are two ways to implement a Covered Calls strategy.
- Selling call options on stocks you already own
- Establishing a new position with a buy stock and sell call at the same time
Part 1 of this piece will deal with point 1 in the above. That is, I’m going to assume that you already own shares in a company and are looking for some additional income from options trading and want to know how to select the right call options for this.
Higher Premiums = Higher Returns
When it comes to selling, you always want to sell at the highest price possible. This is also the case when writing call options over stock. You want to sell options that have the highest premiums.
However, this doesn’t mean selling deep ITM options or options that are expiring in two years. You will be looking at options that are close to expiration and that are out-of-the-money in order to take as much advantage as possible of time decay.
Time decay is not linear and its effects vary per option. Time decay begins most rapidly for OTM options and the option has less than 30 days to expire.
For this reason, you will initially want to be looking at call options that:
- Have less than 30 days left to expire, and
- Are out-of-the-money
Now that you’ve narrowed down your expiration criteria, it’s time to look at the available option series.
I would suggest looking at large, blue chip stocks to trade. Why? Because they will have more option series to choose from, such as weekly options, and also provide more liquidity in the options that are traded. If you choose an obscure, lesser known stock, it may only have quarterly and/or monthly option series that may be outside the range you’re looking for.
For this illustration, we’re going to look at MSFT.
MSFT is a heavily traded stock with lost of options available to trade; quarterly’s, monthly’s and weekly’s. In fact, at the time of writing there is an option series with an expiration every week for the next 8 weeks! Given our criteria of 30 days, the August 18th series (today July 19th) seems most appropriate.
The reason not to go any shorter regarding expiration dates is because the call option premiums will be too low to make the trade worthwhile.
MSFT shares are closed out the 19th trading session at $73.86. Below you will find the out of the money call option closing prices for the August 18th expiration:
MSFT Option Closing Prices. Stock = $73.86
| Strike | Price | % Return |
|---|---|---|
| 75 | 1.32 | 1.79% |
| 77.50 | 0.58 | 0.79% |
| 80 | 0.26 | 0.35% |
| 85 | 0.05 | 0.07% |
At this point, you will need to decide what strike price to sell. This decision will come down to risk/reward.
The table above shows the closing prices of 4 out-of-the-money call options and also their % return. What this number shows is two things:
- The % return selling the option premium will have on your investment of buying the shares at $73.86.
- The downside breakeven point if the stock goes against you
If you go with the 1st out-of-the-money option, the $75 call option, selling the option will provide you with $132 in your account in premium received (1.32 x 100). The return calculated assumes the market value of the shares, which is currently trading at $73.86. As each option contract represents 100 shares, we’ll assume that you have $7,386 in working capital on this trade. This may be lower, however, as we’ve assumed that you already own the shares so your actual purchase price may be different here.
If MSFT shares trade lower, then you have a 1.79% (or higher) buffer before the trade will be losing money.
Keep in mind though that if the stock keeps trading higher then your shares will be “called” away, meaning you are obligated to sell them at the strike price to the buyer of the call option. In this case, not only will you keep the premium of $132 but you will also make a profit on the share sale of $114 ((75 – 73.86) x 100). Given that the 75 level is close, there is more chance of the shares reaching that level than any of the other strike prices.
If you take the $80 strike price, sure, there is less chance of being exercised meaning you keep the stock and can write another call the next expiration but you are only going to receive $26 in premium. Plus, your breakeven level is also lower at only 0.35%.
As mentioned in the above paragraph, the possible downside to the strategy is that you will lose the shares if the market rallies past your sold strike price as the option buyer will “call” on your obligation to sell the stock at the strike price, so keep that in mind when choosing the right strike price for your covered call.
Next, we’ll look at how to scour the internet to find opportunities for buy-write covered calls i.e where you don’t have a position at all and you establish both stock and call at the same time.