Income Options: Covered Call Strike Selection

Selling covered calls is a common options strategy for investors looking to generate income from stocks they buy or already own. But there are some basics to keep in mind, especially when it comes to choosing the optimal strike price.

As a refresher, a covered call is an options strategy where one call option is typically sold for every 100 shares of stock the investor owns. The premium collected from selling the call option goes into the call seller's account, and in exchange for the premium, the call seller agrees to sell their underlying stock at the strike price at any time up until expiration.

Here's how the strategy can work. Assume a stock is priced at $60 and you sell a 30-day, 65-strike call for $2. The stock can move up, down, or not at all, so you'd think there'd be three potential outcomes. In reality, if you hold the option until expiration, there are only two: either the stock has reached or surpassed the strike price of $65, or it hasn't.

If the stock is $65 or higher at expiration—again, assuming you hold the position through expiration—then you’ll likely receive an assignment notice that your stock has been sold at $65. But because you brought in $2 (which is really $200 per options contract because the deliverable of a standard options contract is commonly 100 shares), think of it like selling your shares at about $67. No matter how far (or how little) beyond $65 the stock has gone, your profit and loss is figured as if you simply sold your stock at $67 minus transaction fees.

With the stock below $65, assignment is much less likely, but not impossible. If you're not selling the stock at the $65 strike, calculate your unrealized profit and loss based on the purchase price of the stock, minus the credit from the call option sale. Let's assume you bought the stock at $60. With the call premium figured in, from an unrealized profit and loss perspective, it's as if you paid $58. If you collect another $2 at the next expiration, figure your unrealized profit and loss as if you bought the stock at $56.

Early assignment is also a possibility. If the stock is above (or even near) the strike price at any time prior to or at expiration, the stock could potentially be called away. Calls are sometimes assigned ahead of ex-dividend dates as well because call holders sometimes exercise the contract to own the stock in time for the dividend payment. If your goal is to keep the stock, then it might make sense to close the call option ahead of the expiration or, in some cases, ex-dividend dates. Once you receive the assignment notice, it's too late to close the position. Shares will be called away at the strike price.

Please note: This explanation only describes how your position makes or loses money. It doesn’t include transaction fees, dividends, or any potential tax implications.

Note that a lot hinges on whether the call is assigned, so it's important that you strategically select your strike price.

There's no single answer to choosing a strike price for the covered call, but here are some ideas to consider:

• Select a strike where you're comfortable selling the stock. If the stock is above the strike price at or near expiration, shares will likely be called away (sold at the strike price).
• Some traders favor strike prices that have relatively narrow bid/ask spreads. For example, all else being equal, an option contract quoted at $1.02 to $1.05 is better than a strike with a $1.00 to $1.50 bid/ask spread.
• Pick a strike based on its probability of the option being in the money (ITM) at expiration by looking at its delta. For example, a call option with a 0.25 delta is read by some options traders to imply there's a 25% chance of it being above the strike and a 75% chance of it being below the strike at expiration. The percentages are not exact, of course, but some consider delta a rough estimate for the probability of the option expiring ITM.

Covered calls, like all trades, are a study in risk versus reward. The choice of strike price plays a major role in this strategy, so make your selection according to your risk tolerance and the covered call's potential rewards.