Recommended Option Strategies #1: Covered Call Writing. Part II

Choosing which option to write

Reminder: When writing covered calls, you own 100
shares of stock and sell one call option.

Important: There is never a ‘best’ option to sell. Different investors, each with his or her
investment objective, risk tolerance, and minimum profit objective can choose a
different option that is entirely appropriate for them – but which is
inappropriate for you.

 

Month: You will have at least four
different months from which to choose

· Options which
expire first (the ‘front’ month’) have the most rapid time decay. Time decay is good for option sellers.

· Options which
expire in the latest month are the most costly and thus, by selling them, you
collect the most cash (now) and have greater protection against a market
decline.

· As you gain
experience, you will learn whether front month, 2nd month or other
is more appropriate for you.

 

Strike Price: You have at least three choices. Volatile stocks have many strike prices

· In the money
options: The stock price is higher than the strike price

o The lower the
strike price, the higher the option premium, but there's less profit potential

o The higher the
strike price (remember we are talking about in the money options) the greater
the time premium

o Your maximum
profit potential is the dollar amount of the time premium in the option

 

· At the money
options: The strike price is equal to (or very near) the stock price

o These options
have more time premium than any of the other options and thus, are attractive to sell

· Out of the money
options: Strike price is higher than
stock price

o If the strike
price is too high (compared with the stock price) the premium is very
small. Don’t sell these options

o OTM options can be sold by very bullish investors who want the chance to earn large
profits.  But remember that profit only arrives when the stock rallies.  If the stock holds steady or declines, you may discover that cash premium you collected was too small to make the process worthwhile.

The
space here is too short for a more detailed discussion of how to choose a
strike price that affords a good combination of protection (if stock declines)
and time premium. That information is
available elsewhere. But paper trading
for a few months can give you a great deal of insight.

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