How can you tell which at-the-money option yields the best return?
Too often, options traders make the mistake of equating the best dollar value of premium as the best value. But this is not always the case.
A comparison of three stocks and their options makes the point. Below are the Wednesday closing prices for these stocks, along with the bid prices for selling short call options that expiring on Sept. 16.
Lockheed Martin (LMT) shares closed at $261.30. The 260 call had a bid of 3.90.
Honeywell (HON) shares closed at $116.03. The 115 call option had a bid of 2.23.
General Dynamics (GD) shares closed at $151.47. The 150 call option had a bid of 2.15.
At first glance it appears that Lockheed Martin is the most attractive of these three, with an option price substantially higher than the other two. When you calculate the yield, however, the picture changes. For this calculation, divide the option premium by the strike price:
Lockheed Martin's 260 call option has a bid of 3.90. 3.90 ÷ 260 = 1.5%.
Honeywell's 115 call option has a bid of 2.23. 2.23 ÷ 115 = 1.9%.
General Dynamics' 150 call option has a bid of 2.15. 2.15 ÷ 150 = 1.4%.
As this exercise reveals, the yield on Honeywell is the best of the three, followed by Lockheed Martin and then General Dynamics. Looking only at the dollar value is misleading. Based on this example, in which Honeywell trades at less than one-half the value of Lockheed Martin, opening two covered calls on 200 shares produces the following results:
Honeywell $116.03 @ 200 shares = $232.06, and two 115 calls @ 2.23 = 4.46.
In this case, doubling up the number of shares and opening two covered calls produces the best yield of the three and also yields a higher dollar value.
Any trader embarking on trades such as covered calls needs to look beyond the dollar value of the option premium. The only accurate system for selecting the best yield is to divide premium by the strike. This reveals the true picture and indicates the highest profits to be gained.
Besides blogging at TheStreet.com, Michael Thomsett also blogs at the Seeking Alpha and several other sites. He has been trading options for 35 years. He also teaches on the Candlestick Forum website. To check membership, go to Candlestick Forum membership. His new book can be viewed at tinyurl.com/z44kzlu