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Thursday, February 28, 2008

Picking a Strike Price

One of the final steps in analyzing a potential covered calls position prior to its purchase is deciding which expiration month and at which strike price to sell the options. For this advisor, the near-month expiration is almost always the preferred choice, and the reasons for this preference were explained in a prior post (Link) on this blog site. So for the Covered Calls Advisor, picking the expiration month is a very straightforward process -- simply pick the nearest-month option. But which strike price should be selected? Should an out-of-the-money(OTM), at-the-money(ATM), or in-the-money(ITM) strike price be chosen? This topic is the focus of the remainder of this article.

The Covered Calls Advisor's current overall stock market outlook is always shown at the top of the right-side column of this blog. As you might recall, two prior articles (Developing an Overall Stock Market Outlook and Changes to the Overall Market Outlook) described the seven measures now used by the Covered Calls Advisor to determine the current Overall U.S. Market Meter indicator. These seven factors are:
1. U.S. Earnings and Bond Yield Spread
2. Rest-of-World Earnings and Bond Yield Spread
3. Inflation
4. Real Earnings Growth
5. Current Versus Expected P/E Ratios
6. Investor Sentiment (also known as Price Momentum)
7. Gut Feeling

At the present time, the U.S. Market Meter shows that the Covered Calls Advisor's current outlook is "SLIGHTLY BULLISH; and the corresponding investing strategy is: SELL SLIGHTLY OUT-OF-THE-MONEY COVERED CALLS." This doesn't mean that every covered calls position established in our portfolio should be 'slightly out-of-the-money'-- that is neither practical nor desirable. But, a covered calls portfolio should nevertheless, on average, provide a good reflection of our current 'slightly OTM' preference. The average preference for the various possible Overall Stock Market Investing Outlook categories is:
Very Bullish -- Sell Deep OTM Covered Calls
Bullish -- Sell Moderately OTM Covered Calls
Slightly Bullish -- Sell Slightly OTM Covered Calls
Neutral -- Sell ATM Covered Calls
Slightly Bearish -- Sell Slightly ITM Covered Calls
Bearish -- Sell Moderately ITM Covered Calls
Very Bearish -- Sell Deep ITM Covered Calls

For a practical example, let's consider how these guidelines apply to the current Covered Calls Advisor Portfolio (CCAP). CCAP now contains 13 covered calls positions (Note: the current CCAP positions can be found in the right-side column of this blog) that were distributed as follows when the positions were first established:
Deep OTM (more than 6.0% below the strike price) -- 2 positions
Moderately OTM (from 3.1% to 6.0% below the strike) -- 1 position
Slightly OTM (from 1.1% to 3.0% below the strike) -- 4 positions
At-the-Money (from 1.0% below to 1.0% above the strike) -- 3 positions
Slightly ITM (from 1.1% to 3.0% above the strike) -- 2 positions
Moderately ITM (from 3.1% to 6.0% above the strike) -- 1 position
Deep ITM (more than 6.0% above the strike price) -- no positions

Based on the current 'slightly bullish' market outlook, it is observed that only 4 of the 13 positions corresponded to the most preferred 'slightly out-of-the-money' category. Nevertheless, the overall portfolio does, on average, most closely reflect the 'slightly bullish' current overall market sentiment of the Covered Calls Advisor. In addition, it is noted that the OTM positions were established in those companies where this advisor feels most bullish about the stock's appreciation prospects and also where there is a greater likelihood that the CCAP would likely want to retain that particular stock for writing additional covered calls in future months. Conversely, the ITM positions were established where our bullish conviction in a particular company is not as strong and where our primary objective is to make the maximum possible profit from the position by having the stock called away (the option exercised) on the expiration date.

Picking the strike price is more of an art than a science; but hopefully this article has stimulated your thinking about this topic and will be helpful to you in formulating your own stike price selection process.
As always, I welcome your thoughts, comments, or questions -- which you can share by clicking on the 'comments' link below.

Regards and Godspeed,

1 comment:

  1. Yes, picking the right strategy seems tough. The overall bear market has me looking at 5% to 7% ITM covered calls currently. It seems some opportunities still can earn 5% in a 10-12 day period as well. I'll be reading more of your blog, good luck!