3 Approaches to Strike Selection When Portfolio Overwriting Existing Stocks: A Real-Life Example with Dow, Inc. (NYSE: DOW) – July 3rd, 2023
Portfolio overwriting is a covered call writing-like strategy where deep out-of-the-money (OTM) calls are sold against our long-term buy-and-hold securities. Typically, these stocks and exchange-traded funds (ETFs) are of a low cost-basis and subject to capital gains tax if sold via exercise. This article will highlight 3 ways to guide us to appropriate strike selections.
3 ways to select portfolio overwriting strikes
- Delta: Approximate probability of a strike expiring in-the-money (ITM) at expiration and subject to exercise
- Implied volatility (IV): Establishing a trading range for a specific contract cycle, with an 84% probability of accuracy, using option pricing in the marketplace
- Annualized return goal: Determine a modest annual % return and selecting the strike that will generate the appropriate return (an annualized return goal of 6% will set a 1-month goal of 1/2%)
Real-life option-chain for Dow (2/16/2023 – 3/17/2023)
Note the following:
- With DOW trading at $58.74, the near-the-money $60.00 strike has an implied volatility of 23
- The $62.50 deep OTM strike has a Delta of 14, resulting in an approximate 86% probability of the strike expiring OTM
Using IV to determine the 29-day trading range with an 84% probability of accuracy using the BCI Expected Price Movement Calculator:
The upper end of the range is $62.55, so we will seek a strike near that price and see if it meets our return goal range, say 5% – 6% annualized, as a reasonable goal. The option-chain shows that the $62.50 strike aligns with the upper end of the IV range and also has a similar 86% probability of success using Delta. Let’s calculate that strike.
The BCI Trade Management Calculator (TMC)
The option-chain shows a premium of $0.22 (blue arrow) resulting in an annualized return of 4.56%, aligning with our 5$ – 6% annualized goal.
Discussion
Portfolio overwriting is a strategy where our goals are to generate modest premium cash flow while crafting trades with a high probability of avoiding exercise. Strike selection can be accomplished using Delta, implied volatility or an annualized return goal range, or a combination of the 3 to get a consensus.
Author: Alan Ellman