So you are interested in writing covered calls, which is a strategy where you hold the underlying stock and write call options against the shares.

Having identified an attractive stock to buy, and having ascertained that the options are expensive relative to your view about the stock, the next step is to decide which call option to sell. On the surface, traders would tell you to sell the call that offers the most comfort given your view of the underlying stock. At what strike price are you willing to sell the shares, over what time period are you willing to maintain the position and how much upside potential do you give up in order to have some downside protection.

The comfort analogy supports the position that any option strategy must be designed around your view of the underlying stock. More aggressive traders want to leave room for upside potential, conservative investors will prefer more downside protection, likely over shorter time periods. For most investors the comfort analogy is a bit vague. For those amongst you, here are a few simple concepts that can help you build an attractive covered write.

Choosing a strike is fairly simple since it should be based on your outlook for the underlying stock. Write out-of-the-money strikes if you are aggressive, closer-to-the-money strikes if you are neutral. Typically, the more enthusiasm you have for a stock, the further out-of-the-money the strike price should be. If you are less positive about the stock, write at-the-money or even in-the-money calls. And if you are negative on the outlook for the stock, consider another strategy. Covered call writing is a bullish to neutral strategy, it is not a bearish strategy. It cannot be, because at the base of it, you own the underlying stock.

If you are unsure which option to write, you can always look at the open interest numbers. The open interest can be found on the Quotes page of the Montréal Exchange and is available on most quote terminals. It tells you how many option contracts in that particular series have been opened, and that must be closed out by expiry.

An option contract can be closed out by either exercising the option (if you are the buyer of the option), having an option assigned (if you are the option writer), or if the option expires out of the money.

Usually the at-the-money option has the highest open interest and typically trades at closest to fair value. More activity means more effective pricing. Bottom line, if you are looking to establish a covered call write that will provide a trading pattern most closely associated with a typical option contract, then writing at-the-money calls are your best choice.

Another factor it the time to expiration. Options lose most of their time value in the last three months prior to expiration. During the last ninety days of an options’ life the speed at which time value is lost rises exponentially. Which is a long winded way of saying that traders who sell options should probably be looking to sell shorter term options in order to capture as much of the time value erosion as possible. Typically covered call writers should write options with less than ninety days to expiry.

So we have it. Covered call writing requires a view about the underlying security, which should lead to an opinion on the appropriate option to write. If you are looking to establish a covered call write that offers the best liquidity, and will most closely resembles the highs and lows of the strategy, look to sell at-the-money calls with less than ninety days to expiry.