Covered Calls: What strike price should you sell?

In this guide, we’ll delve into the intricacies of covered calls and address one of the most fundamental questions: what strike price should you sell? By understanding the nuances of strike price selection, you can navigate the landscape of covered calls with confidence and finesse.

covered call strike prices

In many instances, it is advisable to sell covered calls that are at a strike price above the cost incurred when buying the shares. These calls, known as Out of The Money (OTM) calls, offer the opportunity to generate a modest profit when the shares are called away, thereby increasing the overall yield obtained from the previous options sold.

This strategy, commonly referred to as a buy-write, entails purchasing the desired shares and promptly executing the sale of a covered call with a strike price exceeding the recently paid share price.

Some brokers allow you to place this order simultaneously so it’s executed at exactly the same time. By employing this approach, one effectively secures a profit on the shares in the event of their exercise.

Real life buy-write trade in SWK

I implemented this buy-write strategy myself recently, buying 200 shares of Stanley Black & Decker Inc, ticker symbol SWK.

I paid $81.60 each for the shares on May 18th and immediately sold the June 16, $85 covered call option. I was paid a premium of $289.81 for this trade which brought my cost basis down to $80.16 per share.

This stock was also going ex dividend on June 2nd, so I was able to bag the dividend as well on this trade.

P&L of my SWK buy-write covered call position
buy write covered call in SWK using trading view
Here is a chart showing my SWK buy-write covered call campaign

The Impact of Stamp Duty on UK Shares

If you are in the United Kingdom, when selecting the appropriate strike price it is imperative to factor in the impact of stamp duty levied on the purchase of UK shares. The bothersome half percent duty should be considered, necessitating that the strike price of the calls exceed the share price by at least 0.5% to ensure a breakeven outcome. Commissions should also be taken into account for similar reasons, although their negligible nature often renders them inconsequential to overall profitability.

Which Strike Prices should you consider for a Covered Call?

Here’s a useful guideline I like to follow:

If you’re purchasing shares and immediately selling a covered call, it’s generally recommended to sell the call option with a strike price slightly higher than the current share price. This advice takes into account the 0.5% stamp duty on UK shares.

However, what if you decide to sell the call option at a later point after you’ve already bought the shares? There could be various reasons for this scenario.

For instance, you might have purchased the shares without initially considering selling covered calls, or you could have acquired the shares using a cash secured put option. Or you might have been slowly buying shares in small increments so you could then eventually get to 100 shares so you can start selling covered calls on them.

Alternatively, this could be the second or subsequent call option you’re selling on the same shares, or you may have separated the two parts of the transaction due to other factors.

In essence, the current situation is that the price of the shares you purchased may either be trading higher or lower than your initial buying price.

If the price is higher, there is no cause for concern. You can still generate a favourable premium by selling a slightly out-of-the-money call option, which allows you to secure a solid profit on the shares if the option is exercised. In fact, you are likely to realise an even greater gain on the shares, considering that their price has already surpassed your purchase price.

The Wheel Strategy: How to Repair a Position that has Gone Against You

In such a scenario, if you decide to sell a covered call option with a strike price slightly higher than the current share price to maximise your potential returns, the strike price could actually be lower than what you paid for the shares. Consequently, this implies that you would be solidifying a loss on the shares if the call option is exercised.

This scenario may occur soon after you have sold a put option and it has been exercised. The exercise of the put option indicates that the stock price is lower than the strike price of the put.

Ideally, the stock price will not be significantly lower than your purchase price, and it will recover quickly.

Additionally, you may have earned enough put premium to compensate for the potential loss. However, you should be aware that this situation can arise.

Fortunately, this is not a catastrophic event. My Dividend On Fire strategy has a significant advantage in that you can still generate a net profit, even if the stock price decreases significantly, or if you ultimately sell the shares at a loss.

This is possible because you can sell call options with strike prices lower than the stock’s purchase price and still earn a profit if the options are exercised. This is achievable if the total premium received from selling call and put options is greater than the loss incurred from buying and selling the shares.

Understanding this concept is crucial for transitioning from individual trades to an options wheel approach as at some point you will have to repair a position that has gone against you. I will elaborate on this later, but for now, let’s recap what was discussed above.

Ideally, when using the Dividend on Fire strategy, you should always sell a call option with a strike price higher than the total cost of purchasing the shares (including stamp duty and commissions).

This will allow you to secure a profit on the shares if the call option is exercised, while also receiving the option premium. However, it is still possible to make a profit even if you sell a call option with a strike price lower than the cost of purchasing the shares.

This is because any loss incurred from the shares, if the call option is exercised, can be offset by the premium received from selling the call option.

If you sell multiple consecutive calls on the same stock, the accumulated premium can be used to offset any loss on the shares, resulting in an overall profit. Additionally, if you complete a full Dividend on Fire life cycle, you can also factor in the put premium and any dividends received in this calculation.

Further, let’s say your shares are eventually called away resulting in a net loss of say -£700. You could then sell an ATM and make £300 in premium.

This ATM put option helps you re-enter this position and thus perhaps halving your loss to £-300 since you could have earned £300 in premium from selling the ATM put option.

Supposing this is a stock you still want to hold you could then begin running the wheel strategy on this stock again and start selling calls if your ATM put gets assigned.

Selling puts and covered calls have a powerful, yet frequently disregarded, feature that can transform a losing share trade into a profitable position overall.

To summarise, if you are selling covered calls on shares you already own, you should still evaluate the strike price’s proximity to the current share price and its yield. However, it is crucial to consider the strike price concerning the original share purchase price to avoid securing a loss if the option is exercised.

Strike Price Selection: Out-of-the-Money (OTM), At-the-Money (ATM), and In-the-Money (ITM) Calls

Here is a general guideline: When selling a covered call on previously purchased shares, it is best to choose a strike price that is higher than the share purchase price and slightly out-of-the-money (OTM).

If this is not feasible, select a strike price that will result in an overall profit (including option premiums) if the call option is exercised.

Lastly, for the sake of thoroughness, I have focused on selling out-of-the-money (OTM) calls because it is the simplest approach and the most commonly used. Nevertheless, you have three options to consider when selecting a strike price.

  1. You have the option to sell out-of-the-money (OTM) calls, where the strike price is above the current market share price, if you have a bullish outlook on the stock.
  2. Alternatively, you can sell at-the-money (ATM) calls, where the strike price is very close to the market price, if you are neutral on the stock.
  3. Finally, you can sell in-the-money (ITM) calls, where the share price is already above the call strike price, if you have a bearish perspective on the stock.

In-the-Money (ITM) Calls: Pros and Cons

Selling an in-the-money (ITM) call will result in a substantial premium, comprising both the extrinsic and intrinsic value, which is caused by the strike price being below the share price.

At first glance, this may seem like an attractive option, but it is essential to remember that the intrinsic value in the option price implies that the holder can purchase the shares at a lower price than the current market value. Consequently, if the call option is exercised, you will incur a loss on the shares.

However, this approach also implies that the shares’ value may decrease after setting up the covered call, yet still be called away upon the call’s exercise.

In such a scenario, you would lose the same amount on the shares as the intrinsic value earned when selling the call, resulting in a break-even situation. Nonetheless, you would still receive the extrinsic component of the option premium.

This strategy is entirely reasonable, particularly if you are bearish, and it provides a downside buffer on the shares. However, the extrinsic premium component may be lower than that of an out-of-the-money (OTM) call, it is more difficult to comprehend conceptually, and you may miss out on any potential share price increase.

While in-the-money (ITM) calls provide added protection, they are more likely to be exercised. As a general rule, I prefer to avoid frequently buying and selling shares to minimize stamp duty costs and maintain my shares for dividend purposes. This implies that my shares should not be called away too frequently. For this reason, I recommend selling slightly out-of-the-money (OTM) calls as the default option and ensuring that the selected strike price does not result in a loss if exercised.

Read Also: Buying Back Your Covered Calls And Cash Secured Puts

FAQs:

What is an Out of The Money (OTM) call?

An Out of The Money (OTM) call is a type of covered call where the strike price is above the current market share price. This call offers the opportunity to generate a modest profit when the shares are called away, thereby increasing the overall yield obtained from the previous options sold.

What is the impact of stamp duty on UK shares?

When selecting the appropriate strike price for UK shares, it is imperative to factor in the impact of stamp duty levied on the purchase of UK shares. The 0.5% duty should be considered, necessitating that the strike price of the calls exceed the share price by at least 0.5% to ensure a breakeven outcome.

When selling a covered call on previously purchased shares, it is best to choose a strike price that is higher than the share purchase price and slightly out-of-the-money (OTM). If this is not feasible, select a strike price that will result in an overall profit (including option premiums) if the call option is exercised.

What are the three options to consider when selecting a strike price?

The three options to consider when selecting a strike price are out-of-the-money (OTM) calls, at-the-money (ATM) calls, and in-the-money (ITM) calls. The selection should be based on your outlook on the stock, with OTM calls being suitable for bullish outlooks, ATM calls for neutral outlooks, and ITM calls for bearish outlooks.

Kevin S

Kevin S

Greetings, I'm Kevin! I am now a full time options trader and investor. I am thrilled to have the opportunity to share my knowledge and expertise with you. My objective is to assist you in navigating the complexities of option trading, regardless of whether you're a beginner or an experienced trader looking to enhance your skills. I'm excited to accompany you on your journey to mastering the art of option trading. Let's make this year an extraordinary one for you!

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Kevin S

Kevin S

Greetings, I'm Kevin! I am now a full time options trader and investor. I am thrilled to have the opportunity to share my knowledge and expertise with you. My objective is to assist you in navigating the complexities of option trading, regardless of whether you're a beginner or an experienced trader looking to enhance your skills. I'm excited to accompany you on your journey to mastering the art of option trading. Let's make this year an extraordinary one for you!

About DividendOnFire.com

Welcome to Dividend On Fire, we are a site dedicated to options trading! We specialize in helping investors generate passive weekly or monthly income through selling cash secured puts and covered calls.

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