Positioning of strike and expiration and proximity are crucial to the success of a covered call strategy. Selection of the elements requires awareness of (1) level of volatility, (2) degree of time value and (3) proximity between current value of the underlying and strike of the short call. The three elements that define the well-selected covered call: Strike, expiration, proximity.
Strike selection should always be your starting point. The strike of a covered call should always be higher than your purchase price of the underlying stock. (Exception: When the net of price per share, minus premium gained from selling the call reduces the basis, a strike may be equal to the purchase price.)
If your stock price has declined so that exercise would create a net loss, the covered call should not be opened. The strike that produces a net profit and is as close as possible to the current price of the underlying is most likely to yield the highest premium, and to reflect increased implied volatility.
Expiration is the second important key. New traders may be tempted to select expiration far out because the dollar value of calls is higher. However, your overall premium income will be greater when you use shorter-term calls and write more per year. Why is this? The answer lies in acceleration of time decay. Time value falls rapidly during the last two months of an option’s life, so picking expirations within this 60-day window maximizes outcomes. Annualizing net returns proves this point. A one-month call’s return, multiplied by 12 (months) creates the annualized equivalent. It will be higher than the equivalent 3-month net return multiplied by annualized factor of 4.
Proximity of the call’s strike to the current trading range borders is the third key element. When the price of the stock is trading near support, the timing is poor for writing covered calls. When the price is close to resistance, timing is better. Price is normally expected to cycle back toward mid-range, so the proximity of strike, combined with expiration, define the well selected covered call. To open an equivalent position at the bottom of the swing, consider the uncovered put. It has the same market risk as the covered call, but timing near support makes more sense than the covered call. Focus on one-week short puts. Options expiring in one week (on Friday) will lose 34%, on average, of their remaining time value by Monday (one trading day but three calendar days).
One additional point: Avoid having covered calls open at two times of the cycle. First is the period immediately before-ex-dividend date, especially when the call expires right after. This is the most likely window for early exercise of in-the-money calls. An owner of a call in the money can exercise the day before ex-date and then sell shares on ex-date. This means the quarterly dividend is earning in a holding period of only one day. The second time to avoid having a covered call open is in the period right before earnings, especially if the company has a history of earnings surprises.