Chapter 7: How to Choose the Right Covered Call
Core idea
The right covered call starts with the right underlying stock
The temptation, especially for beginners, is to scroll an option chain looking for the fattest premium and sell that one. That is the wrong direction of attack. The premium is a symptom; the underlying stock is the cause. A juicy premium almost always means the market expects large price swings — and large swings cut both ways, with the seller fully exposed to the downside.
Pick the stock first. Look for blue-chip companies, slowly rising price trends, low to moderate volatility, and businesses you would be content to hold for months without any options activity at all. Only once you have a suitable underlying does the option chain become useful.
The ideal market environment is boringly bullish
Covered call sellers thrive in markets most other investors find frustrating: flat, sideways, or slowly drifting upward. In that environment time value bleeds steadily into the seller’s pocket without dragging the underlying stock through any cliff-edge moves. Roaring bull markets cap your upside at the strike; sharp bear markets erase your stock value faster than the premium can cushion. The sweet spot is calm.
Why it matters
Premium is compensation for the risk of holding the stock
A high premium does not mean a great trade — it means the option market is pricing in turbulence. If you sell a richly priced call on a volatile name and the stock drops 15 percent overnight on an earnings miss, the premium you collected covers a tiny fraction of the loss. Choosing a stock you are genuinely willing to own at slightly lower prices is the foundation of risk management for this strategy.
Strike choice picks your trade-off explicitly
Out of the money strikes leave room for the stock to appreciate before the cap kicks in, but they pay less. In the money strikes pay the most and offer the best downside cushion, but they almost guarantee the stock will be called away. At the money strikes split the difference and tend to maximize total return when the underlying barely moves. There is no universally best choice — there is only the choice that matches your view of the stock and the market.
Key takeaways
Key takeaways
- The single most important decision is the underlying stock, not the option premium.
- Avoid highly volatile names like fast-moving tech stocks unless you specifically want a high-premium, high-risk strategy.
- The ideal environment is a flat to slowly rising market that lets time value erode without big stock moves.
- Out of the money calls preserve stock upside; in the money calls maximize premium but almost certainly result in assignment.
- At the money calls maximize total return when the stock barely moves, making them popular with neutral-to-mildly-bullish sellers.
- Defensive writers prefer in the money strikes for the larger downside cushion the bigger premium provides.
Mental model
Read it as: Filter the underlying first — if the stock is too volatile or trending down, stop. Then filter the market environment. Only then choose a strike that matches your view, whether that view is bullish (OTM), neutral (ATM), or defensive (ITM).
Practical application
- Screen for the right stock — Use your broker’s screener or fundamental and technical analysis to find blue-chip names with low to moderate volatility and a gentle uptrend.
- Assess market context — A choppy, slightly bullish broad market is ideal. Avoid selling calls during obvious market peaks or sharp downtrends.
- Decide your stance — Are you bullish on the stock and want upside (OTM), neutral and want maximum cash flow (ATM), or defensive and want downside cushion (ITM)?
- Compare three strikes side by side — Pull the option chain and write down the premium, breakeven, and maximum profit for one OTM, one ATM, and one ITM strike.
- Pick an expiration that matches your time horizon — One month is the most common; weekly options work for traders, LEAPS for longer-term writers.
- Confirm the worst case is acceptable — If the stock dropped 10 percent, would the premium still leave you comfortable holding the position? If not, choose a different stock or a more defensive strike.
Example
Comparing three strikes on the same stock
Imagine Meridian Foods is trading at $50, and you own 100 shares. The one-month option chain shows:
- $48 call (ITM) — bid $2.80. Premium is $280; if the stock stays anywhere above $48 at expiration, the shares are called away at $48 for a $200 capital loss versus today’s price, but offset by the $280 premium for a net $80 profit. The cushion is solid.
- $50 call (ATM) — bid $1.40. Premium is $140; if Meridian closes exactly at $50, you keep the premium and the shares — maximum return per unit of movement.
- $52.50 call (OTM) — bid $0.55. Premium is $55; if Meridian rallies to $52.50, you keep premium plus a $250 capital gain on the stock, for a $305 total — the best result of the three if the stock cooperates.
There is no universal winner. A defensive writer expecting a flat to slightly weaker month picks the $48 strike. A neutral writer picks $50. A mildly bullish writer who would not mind a small capital gain picks $52.50. The chain is doing exactly what it should — pricing each view differently.
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