November 20th, 2008Picking A Strike Price For Covered Call On McDonalds
Here’s a helpful tip for those wanting to learn and utilize stock options in today’s market – sell options when volatility is high and buy options when volatility is low. If you are still uncertain as to whether 2008 is a high or low volatility market, then you probably need to just stay out of the market.
For those that recognize the answer that 2008 is a high volatility market and want to SELL OPTIONS, then covered calls are one of the best ways to do so. Once you pick a stock to utilize a covered call on, you then need to pick an expiration month and strike price to sell for your cover. Below is the December option chain for McDonalds from Yahoo Finance, as of the close of day November 13th. McDonalds closed today’s trading session at $52.91.
If you are going to do a covered call on McDonalds, here are the steps:
Step 1 - Buy and read the following book from Amazon. It’s just to dangerous to think you can trade options after reading this short post. Just click on the book cover below to purchase.
Covered Calls and LEAPS–A Wealth Option + DVD: A Guide for Generating Extraordinary Monthly Income (Wiley Trading) by Joseph R. Hooper
Step 2 – Pick an expiration month. November expiration has only 1 trading day left so that is out of the question. December expiration is on December 19th, which gives plenty of time to collect some good premium, especially in this high volatility market. January expiration is also an option. Going beyond January is also possible, but not very appealing to me personally because it ties up the position for to long without much benefit of additional premium.
Step 3 – Analyze the potential return for getting called out of the position based on each strike you are considering. The most popular strikes are going to be at the money, or a few strikes in or out of the money. The separation of “IN” and “OUT” of the money is shown above by the change from yellow to white shading.
Example: Analyze the potential called out return of purchasing 100 shares of McDonalds and selling a December 50 strike. Assume today’s closing price and option chain are still available.
- Buy 100 shares for $5,291 and SELL TO OPEN (1) contract of the December 50 for $520.
- Net outlay and net risk is $5,291 – $520 = $4,771
- Assume McDonalds follow through with the promised dividend payment of $50 prior to expiration
- If McDonalds ontinues to trade above $50 on December 19th, then you will be forced to sell your 100 shares for $50 each, or $5,000
- Total collected from being called out is $5,000 + $50 (dividend) = $5,050
- Profit from trade = $5,050 – $4,771 = $279
- Net return if called out = $279 / $4,771 = 5.8%
- Downside protection breakeven point = $4,771 – $50 (dividend) = $4,721
Can you live with this scenario? If so, then it is a good candidate. If not, then perform the same analysis for other strike prices, and possibly other expiration months.
Step 4 – Decide on the combination of strike price and expiration month that is the most appealing to you personally. It is a personal and subjective decision that takes your personal risk tolerance into play. Nobody can tell you the correct answer except for you.
Good Luck, and as always, trade at your own risk!