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How to Determine the Best Expiration Time and Strike Price when Selling Covered Calls

In determining how long an option to write when selling covered calls, we should remember that a 3-month option will have a higher average monthly return than a 6-month or 9-month option.

If you determine that the stock price will be lower over the next 3-months, you should consider writing a 9-month option.  This will produce more premium than a 3-month call.  Then, you can close this when the stock pulls back to collect the profit and sell another call option.

If you decide that the stock price will increase in the next 3-months, then it will be best to sell a 3-month option and write another call option on expiration.  This will total more premium than an original 6-month or 9-month option.

If you follow my strategy, just replace a 3-month option with a current month option to generate more monthly income.

Let’s use Coca-Cola (KO) as an example.  KO is trading at $69.00 at this time.  Here are the option premiums:

  • Aug 2011 70 calls – $0.55
  • Nov 2011 70 calls – $2.00
  • Feb 2012 70 calls – $2.75

If you think the stock will be $65 in 3-months, you should sell the long-term option for $2.75.  When the stock price is at $65, options at this strike will have a premium of around 2.5. You could sell these options at $65 when you close the $70 strike if the stock price declines.  In general, you should get around a 3% return on a Nov call so doing this 4 times a year results in a 12% return not including the dividend.  A 12% premium return still makes a profit even if the stock declines $5.00.

What Strike Price should you choose? Options with a higher strike price are most profitable when the stock price increases but the lowest strike price will perform the best when the stock price declines.  Which stock price should we write? The maximum return potential (highest strike) or greatest downside protection (lowest strike)?

The answer to this questions is to go back to why you are selling covered call options.  The main reason we are selling covered calls is to obtain an assured monthly income.  The biggest risk is that the stock price will fall.  My general rule is to give first preference to the option with the lowest strike price which is usually ATM unless I am expecting a big market correction (ITM calls).

This gives the most protection against a potential stock price decline.  You get the protection and still make a profit when the stock price rises.  The basic thinking of selling covered calls is that you give up a potential for home runs for a steady stream of base hits.  This is what is required to make a steady monthly income.

Bottom line: You should stay with your trading plan based on why you are writing calls in the first place – income.  If you are looking for home runs, you will not find them when selling covered calls.