Your Strike Price Should Be In Line With Your Goals

Includes: F
by: Jacob Steinberg

Selling covered options can provide dividend-like income for the investors. In fact, I would prefer this kind of income over dividend income, because unlike dividend income, the income based on covered-option selling is not deducted from the stock price. For example, if a stock trading for $10 per share issues dividends of $1 per share, this amount will be deducted from the stock price, which is not the case in option writing.

Now the big question remains. How do we pick the right strike price when selling options? For example, let's look at Ford (NYSE:F). Currently Ford's share price is $12.43. If we were to sell covered calls for Ford expiring in June 2012, our possible strike prices are $10.00, $11.00, $12.00, $13.00, $14.00, $15.00. Which one to choose depends on your goals, risk appetite and opinions about how the stock will perform by expiring date.

Strike Price Premium
$10.00 $2.58
$11.00 $1.73
$12.00 $1.01
$13.00 $0.51
$14.00 $0.21
$15.00 $0.08

If you believe for some reason that Ford will not do so well in the near future and you wouldn't mind selling the stock, you may pick a lower strike price and get a higher premium. Setting a strike price at $10.00 would provide you with $12.58 if the call holder were to exercise his option. In this case you would be making little profit, but no loss in case your stock price goes down significantly. If the call expires worthless, you still keep $2.58 premium and good to write another call. You could also set the strike price at $11.00 and earn $12.73 if the call is exercised. If the call doesn't get exercised, you still keep $1.73. Also, if you set the strike price at $12.00, you will earn $13.01 in case the call gets exercised and $1.01 in case it doesn't.

Now, what if you don't really want to sell the stock? You want to hold on to Ford as long as possible, collect dividends along the way and you are only considering selling calls for extra income on top of dividends. Also, because you are more of an income investor, you are not too worried about temporary falls in the stock price. Then you can set a strike price significantly higher than the stock's current price. The higher you set the strike price, the more likely you will to keep your premium AND your stock. But also remember that the higher the strike price is, lower the premium will be. For example, if you set a strike price of $13.00, your premium will be $0.51 per share. Since this call lasts only 3 months, you can write 4 of these in a year and rake in $2.04 in premiums. This is an income yield of roughly 16% and it won't even get deducted from the share price like dividends do.

For my dividend stocks, I set a pretty high price, which I believe is not likely to occur in the short term. For this example, I might pick a strike price at $14.00 or $15.00 in a 3 month period. The first option would yield an annual rate of 6.75% in premiums and the second option would yield 2.57%. If you are an income investor and do not want to sell your stock, setting a high strike price might be the strategy for you to earn additional "dividends."

As demonstrated by the example, investors should pick their strike price accordingly with their risk appetite and personal goals.

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

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Tagged: , , Auto Manufacturers - Major, Options
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