I ran into a situation with last week’s expiration that made me think about the dynamics of a covered call. 

Going into expiration last week, I got assigned on a short put.  It was very close to the short strike price and I had plenty of maintenance, so it didn’t concern me very much.  So, I stuck to my original plan of simply getting assigned.  Going into Monday, I was long the underlying.  As luck would have it, the price of the underlying went up in pre-market trading to where it was slightly above the short strike price (woo-hoo).  It wasn’t above it for long, and I ended up making my decision and my move when the underlying was almost exactly at the original short strike price.

The question that comes up is what strike price should I sell for the next expiration period. 

In the money:  Before the last expiration period, I had made the decision to sell a put below the current price of the underlying.  I would be fine owning the underlying at that price (which I did).  I viewed it as simply getting paid to own the underlying at a price that I would have bought it at anyway.  If I were to sell an ITM covered call, it would be the same concept.

At the money:  This is where the most time decay lives.  If God were to tell me the underlying would stay the same price, I would sell this strike.  However, there is less overall premium than an ITM call.

Out of the money:  I would consider selling this strike price if I wanted to potentially capture some upside of the underlying.  The income would be less, but the potential upside would be greatest should the underlying increase.

I decided to sell an ITM option.  The reason was 2-fold.  The first reason was that I was a bit concerned about the underlying having a pullback.  An ITM call would give the most protection from a slight pullback in the underlying.  The second reason is the inspiration for today’s post.

I had to ask myself the question of weather I was looking to do this strategy for income or appreciation.  In this instance, I am doing this strategy for income.  I’m not looking for this underlying to increase very much (if at all).  I like this underlying for the purpose of the option income it can offer and the stability of its price.  Since I’m not looking for it to increase, it would not make sense to sell an OTM covered call.  I am a bit concerned about a near term pullback, so I didn’t want to be exposed with an ATM covered call.  It is for those reasons that I decided to sell an ITM covered call.  The extrinsic value I captured wasn’t great, but it is enough to make it a profitable trade even if the underlying pulls back slightly. 

This may be a different situation next time, but for now, this was the best decision for this strategy.

If you have any questions or want to learn more about what I do as a financial advisor, feel free to email me at mtosaw@rcmfs.com.