Strike Selection in Covered Calls
May 22, 2017
By: Sage Anderson
One of the most prevalent options trading strategies is the covered call.
A covered call means that a trader is short calls, but owns enough stock against them to "cover" any assignment requiring the trader to sell stock to the owner of the calls.
The risk profile of a covered call is therefore quite different than that of a naked call seller, who theoretically is exposed to unlimited risk. Selling naked calls is effectively like getting naked short stock, which means there's significant upside exposure.
In order to be short a covered call, a trader needs to own at least as much stock as they've put at risk in their short calls. For example, a trader selling 1 call contract would need to own at least 100 shares of the underlying.
However, investors that own large concentrated positions may, of course, sell fewer calls than the amount that would equate to their entire equity holding. If for example, an investor owned 10,000 shares of stock XYZ, they might choose to sell only 10 XYZ covered calls (which would require at minimum 1,000 long shares).
Aside from the number of contracts to sell, traders also need to decide what strike might be most appropriate.
While the ultimate choice of strike may depend on your unique strategy and risk profile, a recent episode of Options Jive highlights research conducted by tastytrade on this subject that may be helpful.
In terms of risk, a covered call strategy performs well when the underlying stock sits still and does not break through the upside strike. In this case, the trader collects all of the premium and retains their entire stock position.
If the underlying stock goes down, a covered call also performs well, because the trader will collect the premium against their losses in the stock position. Without the covered call, the trader would have simply experienced the loss on their stock (with no gain from the short premium).
In the case where the underlying stock goes up, the performance of the covered call will ultimately depend on the specific strike selected and the price of the stock.
In order to better understand how the covered call strategy has performed over time, tastytrade designed and conducted a study that segmented the results by call delta.
Delta is, of course, the Greek that tells us how much an option's price will change for every $1 move in the underlying. So at-the-money options, which are more sensitive to underlying price movement, have higher deltas, while out-of-the-money (OTM) options have lower deltas.
In terms of strike selection, that means that traders selling ATM covered calls would be selling approximately 50 delta calls. From there, going higher on the strike ladder (further out-of-the-money), reduces the delta.
In the study, tastytrade analyzed 50 delta, 30 delta, 16 delta, and 5 delta covered calls to provide a snapshot of the relative performance of covered calls across the delta spectrum. The study used data from 2005 to present and evaluated options with an average duration of 45 days-to-expiration.
The graphic below highlights the results of this study:
As you can see from the above, the data indicates several important trends.
First, the ATM covered call strategy does not produce as high returns as the other delta levels (on average). Additionally, the 50 delta strategy also missed out on profits the highest percentage of the time (43.96%).
On the other hand, the 16 delta strategy returned the highest average P/L, while missing out on profits only 14.88% of the time.
The results above obviously take into account a broad range of market conditions. Therefore, traders with no opinion on the direction of the markets may lean toward selling lower delta covered calls, such as the 16 delta category illustrated in the graphic above.
However, it's certainly possible that traders may also align their covered call strategy with their view on market direction, which may call for a different choice in strike selection. Obviously, in bear markets, the relative performance of higher delta covered calls will improve.
We hope you'll take the time to review the entire episode of Options Jive focusing on strike selection in covered calls when your schedule allows.
Also, don't hesitate to reach out at firstname.lastname@example.org with any comments or questions.
We look forward to hearing from you!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
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