Options Education – How to Choose Which Call to Sell When Executing a Buy-Write/Covered Call
A Buy-Write/Covered Call is a strategy in which the trader holds a long position in a stock and writes (sells) a call option on the same stock in an attempt to generate income. But how do you best choose which call to sell when executing a buy-write?
At the end of the day, the simplest way to choose which call to sell against your long stock position is to say to yourself “where am I willing to sell my stock?”. If it’s at 50, then you should sell the 50 strike call. If it’s at 55, sell the 55 strike call.
That being said, if you are more of a trader, and are looking to create yield month after month in various stocks then it gets a touch more complicated.
Take for example Snap (SNAP) in which we recently executed a buy-write when the stock was trading at 14.80. Below I am going to layout three different scenarios of profit and loss, breakeven and compare the outcomes.
In-the-money Call Sale
Selling an in-the-money call is the safest way to execute a buy-write as the trader collects a large premium which helps lower the cost basis on the trade.
For example, with SNAP trading at 14.8, we could have sold the July 14.5 Call for $0.87. Here is the breakdown on the returns and breakeven:
Buy Snap (SNAP) Stock at 14.8, Sell July 14.5 Calls for $0.87
Static Return: 4.09%
Breakeven: 13.93
Covered Call Return (if assigned): 4.09%
As you can see by selling an in-the-money call the breakeven on the stock buy drops dramatically. However, the best case profit scenario is limited to 4.09% as the sale of the 14.5 call means that if the stock were to close above 14.5 we would be forced sell our stock position at 14.5.
Slightly out-of-the-money Call Sale
Selling a slightly out-of-the-money call is the trade to make if you are looking for higher returns, though still looking to collect a “decent” call premium.
For example, with SNAP trading at 14.8, we could have sold the July 15 Calls for $0.65. Here is the breakdown on the returns and breakeven:
Buy Snap (SNAP) Stock at 14.8, Sell July 15 Calls for $0.65
Static Return: 4.59%
Breakeven: 14.15
Covered Call Return (if assigned): 6%
As you can see compared to the breakeven of an in-the-money call sale (13.93) the breakeven on this out-of-the-money call sale is 14.15, which is closer to the current stock price, because we sold the call for less premium.
However, should SNAP rise to 15 or above we would also collect an additional $0.20 of profit as our stock holding will have gained value as well. This bumps up the potential gains when compared to an in-the-money call sale.
Far out-of-the-money Call Sale
To create the best profit potential we can sell a call far out-of-the-money. However, because we are selling a call far from the current stock price, we collect a smaller premium.
For example, with SNAP trading at 14.8, we could have sold the July 16 Calls for $0.30. Here is the breakdown on the returns and breakeven:
Buy Snap (SNAP) Stock at 14.8, Sell July 16 Calls for $0.30
Static Return: 2.06%
Breakeven: 14.50
Covered Call Return (if assigned): 10.34%
Because we only collected $0.30 in this scenario the breakeven is now only at 14.50, and the static return, if the stock doesn’t move, is only 2.06%. However, should SNAP rally to 16 or above we would collect that $0.30 from the stock sale, as well as make another $1.20 on the stock holding. This bumps up the best-case scenario to 10.34%.
Conclusion
At the end of the day, I choose the call’s strike price to sell based on the breakeven and profit scenarios broken down above, as well as my thoughts on the market, the strength of the individual stock and current risk level in the portfolio.