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Options Trading: Which Options Give You the Best Returns in Covered Calls?

By  Feb 25, 2010

Topics: Business books

Covered call writers constantly struggle to balance the time element of covered calls with the amount of premium income. Keeping the time exposure short is desirable, but longer-term options have richer premiums because of more time value. But there is a good rule of thumb for picking one short call over another. Most of the time you will do better picking calls expiring within one to two months.

The key to picking the best covered call is really a no-brainer once you see how time decay acts. It falls at the fastest rate in the last one to two months before expiration and this translates to the greatest overall covered call yield -- even though the dollar amount is lower.

The first way to pick a call is to identify proximity between current value and strike price. The ideal covered call has a strike that is one or two points in the money. For example, when the underlying stock trades at $48-49 per share, the 50 call is in the best position for the covered call. This is true for two reasons. First, all of the premium is non-intrinsic and is going to evaporate quickly in the last weeks before expiration. Second, in the event the stock price rises above the strike and the covered call is exercised, you will profit from the fixed strike. This assumes your purchase price of stock was lower than the strike to begin with, a requirement to justify the strategy.

Next, compare premiums for the calls expiring in the next two to three months. You will almost always be able to pick between calls expiring in one month or less, two months or less, and another farther out (depending on the cycle, it will expire in either, three, four or five months).

You will earn a better rate of return picking the option expiring in about one month. This raises another issue: Is the market risk worth what could be a fairly small premium for the covered call? As a general rule of thumb, you need to justify entering the position with an acceptable dollar value or it just isn’t worth committing your 100 shares to possible exercise. For example, you might want to limit yourself to premium of $150 or more. The level is a matter of personal choice.

Later-expiring options invariably offer higher premiums, so the dollar amount versus time is an important deciding point. But to truly compare the return on covered calls, you also need to annualize the return. To make it consistent, first divide the current option premium by the price per share of stock today (don’t use strike or original basis, because either of these can distort the true return). so for example, let’s say the stock is selling for $8 per share. The following calls are available:

            one month                   $150

            two months                   250

            four months                   450

To annualize, you need to calculate the return, and then adjust as if the holding period is going to be a full 12 months. So the annualized return for a one-month term is 12 times more than the straight, un-annualized return. Two months annualizes at six time more; and four months annualizes at three times more:

    one month:                  ($150 ÷ $4,800)  ÷ 1 x 12 = 37.5%

    two months:                ($250 ÷ $4,800)  ÷ 2 x 12 = 31.2%

    four months:                ($450 ÷ $4,800)  ÷ 4 x 12 = 28.1%

The shortest-term call yields the best annualized return. The shorter period also allows the writer to let the position expire (or buy to close) and replace it more often during the year.