Covered Call Writing: Strike Price Selection And The Ellman Calculator

| About: Red Hat, (RHT)

Covered call writing requires a logical sequence of stock and option decisions. Once we have screened our stocks to locate the greatest performing stocks in the greatest performing industries we must make a decision as to which strike price to use. Our choices include:

  • in-the-money
  • at (near)-the-money
  • out-of-the-money

Let's look at the options chain for the December contracts which represent a 4-week period expiring on December 16th. This was the options chain after the November contracts expired:

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Red Hat (NYSE:RHT)- Options chain for the December contracts

With the current market value @ $49.04, I have selected the following strikes to evaluate (additional strikes can also be viewed):

  • $47 in-the-money (green field) generates $3.60
  • $49 near-the-money (yellow field) generates $2.40
  • $52.50 out-of-the-money (purple field) generates $0.95

Next let's enter these stats into the "single tab" of the Ellman Calculator:

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Ellman Calculator- information entered

Once this information is entered in the blue cells, the results appear in the white cells on the right side of the page:

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RHT- Ellman Calculator results

Each strike tells an important story:

$47 (green field):

  • 3.3%, 1-month initial return
  • 4.2% downside protection of the option profit
  • No upside potential

$49 (yellow field):

  • 4.8%, 1-month initial return
  • Little or no downside protection or upside potential

$52.50 (purple field):

  • 1.9%, 1-month initial return
  • No downside protection of the option profit
  • 7.1% upside potential (possible total of 9%, 1-month return)

What these calculations tell us:

  • The time value or option profit for I-T-M strikes offer lower returns than the near-the-money call but the greatest protection for the option premium
  • A-T-M (near) calls provide the highest ROO (initial premium profit) but little or no upside potential or downside protection of the premium
  • O-T-M calls offer less option profit than the A-T-M calls but the greatest total profit potential should the upside be realized or almost realized.

When to use each strike:

  • I-T-M strikes are the most conservative and easiest to unwind because of their high delta (move down in price nearly dollar-for-dollar with stock price decline). Use these when technicals are mixed and/or the market is bearish or volatile.
  • A-T-M strikes can be used when technicals are good and market conditions are positive.
  • O-T-M strikes are used when extremely bullish on the stock and general market conditions are favorable

Laddering the strikes:

There is no law that says you must use the same strike when you have multiple contracts. You can use some of each, favoring a particular strike based on the overall environment.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.