Covered Call Writing And The Ellman Calculator -- Single Tab: Selecting The Best Strike Price

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 |  Includes: WDC
by: Alan Ellman

One of the common flaws found in many of the studies of the covered call strategy is that they select only slightly out-of-the-money strike prices. Needless to say, a majority of covered call writers are also guilty of the same mistake. It is certainly understandable why one would lean to this strike as we ultimately will garner the very highest of returns if the stock does appreciate up to and beyond the strike. This is a strike that should be favored when both market and individual equity fundamentals and technicals are positive.

What if the market or equity technicals are volatile or slightly bearish? Should we not consider the protection afforded by in-the-money strikes? The risk is that the stock will head north and we will miss out on the appreciation. The benefit is that the option buyer is purchasing insurance for us in the amount of intrinsic value of the option premium. This generosity should be given consideration when market or stock indicators dictate. Furthermore, in-the-money strikes have deltas approaching "1″. This means that as the stock moves up or down, the option value will move up or down in a similar amount. If the stock starts declining in value, so will the option premium and it will be less costly for us to buy back (B-T-C) the option to execute an exit strategy.

Once we have selected a stock for our portfolio, we can run the calculation for the different strike prices using the "single tab" page of the Ellman Calculator. This tab allows you to view up to four different strike prices for the same equity.

Procedure:

Simply input the information required into the blue cells on the left side of the single tab page as shown in the figure below for Sandisk (SNDK). All of these figures are gleaned from the option chain:

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(Click to enlarge)

Ellman Calculator- Single Tab- enter info

SNDK is currently trading at $46.62 with three weeks remaining until expiration Friday. We will look at the in-the-money $45 strike, the near-the-money $47 strike and the out-of-the-money $50 strike.

Information Generated:

For each strike price submitted, the calculator specifies ROO (return on option), upside potential, downside protection, share buy down (I-T-M strikes), proceeds, cost basis and annualized returns. All of this information appears in a split second and can be printed to facilitate the best possible investment decisions. The chart below shows these results for SNDK:

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(Click to enlarge)

Ellman Calculator- Single- Final calculations

  • Only the I-T-M strike ($45) offers downside protection as seen in the cell highlighted in yellow.
  • The cells highlighted in green show the actual return on the option when initially sold.
  • The cells highlighted in blue show upside potential if shares appreciate in value.
  • The cells highlighted in red show maximum possible profit percentage for each strike price.

Depending on your market outlook, risk tolerance and stock technicals, you can use this information to select the strike price that best meets your needs.

Disclosure:

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