Which Strike and Month to Write?

Let’s begin this section with a quick review of the different call strikes’ pertinent characteristics in Figure 10.1, which are a permanent benchmark for the covered writer. The delta numbers given are for the current-m0nth options.

Figure 10.1

Call Strike Characteristics Compared
Strike Return Downside Protection Delta Rationale
OTM All time value; usually the 2nd-highest return level uncalled, except when stock pulling back; highest return assigned or not assigned if stock rises. Lowest Usually 25-35%, increases as stock gets closer to strike; lose value very slowly as stock falls Strongly bullish outlook over term of trade or writing to capture high IV
ATM (NTM) All time value; the highest level of uncalled return in all markets. Medium Usually 50-55%; loses value more slowly as stock falls & the strike becomes increasingly OTM The universal strike for most purposes
ITM Time value portion is generally the lowest return level; but when bearish expectations are high, it can be higher than for the OTM calls. Highest; deeply ITM calls can confer quite high level of protection Usually 0.70 to 1.00, increases as stock moves higher; lose value close to dollar-for-dollar as stock falls Extremely conservative; also used when bearish on stock

Every strike involves trade-offs.

The ITM strike offers low return but great downside protection and lowers cost basis. Its high delta is a considerable advantage to closing or rolling should the stock pull back. It is the most conservative write, but essentially bearish.

The OTM strike allows the writer to participate in the underlying stock’s advance, if any, but usually is maddeningly slow to lose time value when the stock pulls back. If the stock advances but not quite enough to result in assignment, extra profit nonetheless will result from selling the stock at the higher price.

The ATM call (or near-the-money call, since stocks are not always conveniently at a strike price) is in many ways the gold standard, since it will always offer the highest return, uncalled. Unless the stock price has recently moved, the ATM call usually will exhibit the highest open interest. If a writer were to blindly sell only one strike in all trades, it should be the ATM.

Keep in mind that different strikes can be blended. For example, half the calls might be sold ATM and half OTM. Doing so would increase premium at trade entry compared to writing only OTM calls; and if assigned on the OTM calls, the overall return would be higher compared to writing only ATM strikes.

Figure 10.2 following compares the ITM, ATM and OTM strikes in the current expiration month for a stock priced at $19.75. Note each strike’s flat and called return and how that strike interacts with the breakeven point.

Figure 10.2

Call Strikes Compared – Same Month
Stock Price

= $19.75

Strike Premium Return Flat Return If Called Breakeven B/E
OTM 22.50 $0.85 4.5% 19.05% $18.90
ATM (NTM) 20.00 $1.25 6.76% 8.11% $18.50
ITM 17.50 $2.95 4.17% 4.17% $16.80
  1. OTM. The return is a staggering 19% if called out, and a hardy 4.5% uncalled. The more bullish the writer, the more sense this strike makes, since if offers the least downside protection and barely more uncalled return than the ITM strike. Plus, the writer profits additionally if the stock moves up at all.
  2. ATM. The 20 Call is slightly OTM, though essentially an ATM call. But being OTM, there is a slight extra payoff if the stock is called out. The return is a very nice 6.7% if not called, but 8.1% if assigned, a better choice if the writer’s outlook is neutral or very mildly bullish. The B/E point is not much lower than for the OTM call, so not a lot more protection has been gained.
  3. ITM. There is no reason to accept the smaller 4.17% return unless the writer expects an imminent pullback in the stock or habitually is quite conservative. If the nearest support level is above the $16.80 B/E point, this strike offers an extra measure of protection.

Call Expiration Months

Assume for purposes of the following table that we have decided to write the 20 strike call on the underlying stock. Our initial reaction is to write the front (current) month’s call. However, other expiration months bear looking at, since their returns might be high enough to warrant being in the trade longer.

Figure 10.3

Expiration Month – Premium Comparison
Expiration Month Premium Trade Duration Flat Return Rate of Return/Day
20C – DEC $1.20 26 Days 6.08% .0023%
20C – JAN $1.55 58 Days 7.86% .0014%
20C – FEB $1.80 83 Days 9.12% .0011%

DEC. The return per day is commandingly better than going further out in time. The January and February calls result in returns of 3% per month or better, which is my goal. But the current December call’s rate of return is vastly higher.

JAN. The JAN calls more than double the time in the trade compared to the DEC calls, but increase the return just slightly, from 6.08% to 7.86%. Note the difference in the rate of return, which drops like a rock!

FEB. Compared to the DEC calls, the FEB calls more than triple the time in the trade and only increase return 50%. The trader must weigh the 50% increase vs. the 300+% trade duration. Time is seriously picking our pocket in this write.

I would never presume to tell any writer how much return he or she should find acceptable. But the rates of return tell the story, don’t they? The further out in time we go, the lower the rate of return will be. Premium compression works for the option buyer, not the seller. While there is no “right” or “wrong” strike or expiration month, if we decide that the 20-strike is the better choice, what justification would there be for accepting the lower rates of return for a JAN or FEB write in the above example? The optimal returns on duration usually are produced by writing the current-month calls; or if there is not much time left in the current month, writing the near-month calls.

One strategy that could make sense in the right circumstances would be to write months out to capture high implied volatility on a good stock that normally carries low volatility (a now-or-never stock) and that in our opinion is unlikely to become volatile despite the news event that is causing implied volatility to spike. We expect premium to collapse with implied volatility, and will buy back the calls then and sell the stock, assuming the stock has not been damaged (always a possibility). Otherwise, lower rates of return certainly do not improve our results.

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