The two commonly touted advantages of a covered call are cash flow and downside protection. When bear markets strike the protective aspect of the strategy becomes incredibly powerful. Today we’re going explore the merits of using short calls for defense and provide some guidelines for strike selection.

Premium = Protection

The protection provided by short calls is easy to calculate. It’s equal to the premium received. A few examples will help illustrate this. Suppose you own a stock worth $100 and have the following one-month calls available:

OTM $110 call: $1 premium

OTM $105 call: $3 premium

ATM $100 call: $6 premium

ITM $95 call: $8 premium

ITM $90 call: $11 premium

Call Strikes

The rule advocated by our covered call trading system – the Tackle 25 – involves selling OTM calls, usually with a delta around 0.40. It seeks to strike a proper balance between protection provided and max available profit. Traders following this prescription would sell the $105 call for $3 in the above table.

In doing so, they would have $5 of potential gain in the stock ($105 strike – $100 stock price), plus $3 of cash flow/protection provided by the call.

Now, suppose the market turns bearish and your focus turns more toward minimizing loss than maximizing gains. In that scenario, you might sell the ATM $100 call for $6, or even an ITM call for $8 or $11.

This is where I often get questions from students, such as:

How deep ITM should I sell?

Can I still make a profit if I sell a deep ITM option?

Questions, questions

The Depths Beckon

Let’s tackle the first query. There isn’t a right answer to how deep ITM you should go when seeking protection. To make a more informed decision, however, you need to know the inherent tradeoff.

Deep ITM call = more protection, less potential profit

Shallow ITM call = less protection, more potential profit

Pick yer poison

When I say shallow, I mean 1 or 2 strikes ITM. Deep, then, refers to strikes that are more than 2 strikes ITM. And, yes, I just made that up.

Here’s a formula you must know to make a proper choice.

Max profit with ITM covered calls = Extrinsic Value

When selling an ITM call option, you obviously can’t make any money on the stock because you’re obligating yourself to sell it at a lower price. Your profit, then, comes from the call premium. But it’s not the entire premium! You have to take out the intrinsic value because that directly offsets the loss you’re locking in on the stock. It’s the extrinsic or time value that makes up the entirety of the potential profit. Let’s add some more detail to our table. “EV” represents extrinsic value, and “IV” represents intrinsic value.

OTM $110 call: $1 premium, $1 EV + $10 stock gain = $11 max profit

OTM $105 call: $3 premium, $3 EV + $5 stock gain = $8 max profit

ATM $100 call: $6 premium, $6 EV + $0 stock gain = $6 max profit

ITM $95 call: $8 premium, $3 EV + $5 IV – $5 stock loss = $3 max profit

ITM $90 call: $11 premium, $1 EV + $10 IV – $10 stock loss = $1 max profit

Mind the math!

With the stock trading at $100, those seeking max protection would consider selling the $95 or $90 covered call. The first provides $8 of protection with $3 potential profit. The second provides $11 of protection with only $1 of potential profit.

One isn’t better than the other. It merely depends on your preference on which offers a better balance between profit and protection.