Delta and Strike Price Selection – January 25, 2021
Strike price selection is the 2nd of our 3-required skills for covered call writing and selling cash-secured puts. I am frequently asked which Delta to use as a guide to a specific strike price. In this article, we will review the factors that guide us to the most appropriate strike price and the role Delta plays in these decisions. In June 2020, Vinh sent me an email regarding a covered call trade being considered with Advanced Micro Devices, Inc. (NASDAQ: AMD) with the stock trading at $50.10 and 19 calendar days remaining until contract expiration. The inquiry was which Delta to use to achieve capital protection?
Option-chain provided by Vinh
- The $46.00 ITM strike has a bid price of $5.10
- The $47.00 ITM strike has a bid price of $4.40
Delta and strike selection
Since one of the Vinh’s stated goals is protection to the downside, in-the-money (ITM) strikes will be favored. In this case, we will review strikes below $50.00. In the BCI methodology, the factor that guides us to the specific ITM strike is our initial time-value return goal range, not a Delta stat. We know that ITM call strikes, by definition, have Deltas between 0.50 and 1.0 but the specific Delta percentile is not the ultimate determining factor. Instead, we turn to our strategy goals. In this case, let’s assume an initial time-value return goal range of 2% – 3% with capital preservation in mind.
Strike selection in the BCI methodology
We check the option-chain for ITM strikes that achieve an initial time-value return between 2% to 3%. In this case, we will review the $46.00 and $47.00 strikes.
AMD calculations with the multiple tab of the Ellman Calculator
The Ellman Calculator shows that both strikes return the stated return goal range of 2% to 3% The downside protection of the time-value returns are significant ranging from 6.2% to 8.2%. The lower of the 2 breakeven prices is for the $46.00 strike which is $45.00. Both are excellent choices based on strategy goals. Basing a strike decision solely on Delta stats (.70 and .75 for these strikes) may or may not achieve our system objectives.
Discussion
Our strike price selections should be based on strategy goals and personal risk-tolerances. Understanding Delta and its impact on our trades is important but using Delta figures as a sole determining factor for our trades decisions may or may not align with our ultimate objectives.
Author: Alan Ellman