Most traders automatically reach for out-of-the-money strikes. It’s almost become options trading gospel: sell OTM calls to collect premium while leaving room for upside. But this conventional way of thinking is leaving money on the table.
An analysis of the numbers reveals a surprising truth – selling in-the-money covered calls could actually provide better risk-adjusted returns and superior downside protection. The key lies in understanding how these positions perform in different market scenarios. Whether the stock moves up, down, or sideways, the mathematics of ITM covered calls really adds up, even though at first glance it may seem counter-intuitive. Let’s crunch the numbers together and challenge what you think you know about covered call strategies.
Understanding Covered Call Performance: Up, Down, and Sideways Scenarios
Let me share my experience teaching and trading covered calls across different market scenarios. I’ve found this strategy to be particularly fascinating because of how it behaves in various market conditions.
Let’s use Apple as an example that is easy to relate to.
Stock Price Increases: The Sweet Spot
Picture this: You own 100 shares of AAPL at $240, and you’ve sold a call option with a $245 strike price for $2 premium. The stock shoots up to $250. Your stock position gains $10 per share ($1,000 total), but here’s the catch – your short call is now $5 in-the-money, meaning you’ll need to sell your shares at $55. However you’ve made $5 per share on the stock ($500) plus kept the $2 premium ($200), for a total gain of $700. Not too shabby for a “capped” position!
And that’s the catch with covered calls – you’re capping the upside. If the price went to the moon, you would miss out on the serious upside. Your gain is more likely, but capped.
Selling this out of the money call does give you upside potential, but doesn’t perform well if the stock price were to move down.
Stock Price Decreases: The Safety Net
During market downturns, covered calls really show their value. Let’s stick with our AAPL example. If the stock drops to $235, you’re down $5 per share ($500), but that $2 premium you collected cushions the blow. Your actual loss is just $300 instead of $500. I learned this lesson the hard way during the 2020 market crash – my covered call positions significantly outperformed my straight stock holdings.
Stock Price Goes Sideways: The Time Decay Sweet Spot
The covered call strategy shines when there is no stock movement, and it’s something I wish I’d understood earlier in my trading career. When AAPL stays around $240, guess what? That $2 premium you collected is pure profit. While your buy-and-hold friends are grumbling about flat returns, you’re sitting pretty with a 4% return ($2/$50) just from the premium.
In this way you’re able to profit without any movement of the stock. If you had held the shares uncovered, they would not have yielded anything. With a covered call you can gain some upside, profit from sideways movement, and have a cushion if the stock goes down in value.
Note on Volatiliy: Stocks with higher implied volatility for covered calls offer juicier premiums. Just make sure it’s not high volatility due to an upcoming earnings announcement or you might get caught in a nasty surprise!
Side note: This strategy does take some patience and discipline. I’ve had moments of FOMO when stocks soared past my strike price, but the consistent income usually makes up for those occasional missed opportunities.
In-The-Money vs Out-of-The-Money Covered Calls: Debunking Common Myths
There’s another question here as to whether to sell ITM or OTM covered calls – I’m going to outline the difference below but I wrote another article spelling out the maths on this, here.
When I first started selling calls, OTM covered calls were the obvious choice because that’s what everyone else was doing. All guidance on Youtube and elsewhere says “sell the delta 30 call on your stock”, which gives you a balance of upside potential and premiums. But after diving deep into the maths and seeing real results in various market conditions, I had to completely change my approach.
Here’s the thing about ITM covered calls that most folks get wrong: they think they’re giving up too much upside potential. Let me share a concrete example that changed my perspective. Take our Apple stock trading at $244. An OTM 242.5 call might get you $1 in premium, while an ITM 238 call could fetch $4.50 ($2.50 intrinsic + $2 extrinsic). If the stock drops to $238, the OTM position loses $2 ($3 stock loss MINUS $1 premium), while the ITM position actually profits $2.50 ($2 stock loss – $4.50 premium). That’s serious downside protection!
Speaking of protection, let’s tackle this “upside risk” myth head-on. I remember one student adamantly arguing that ITM calls would hurt more if the stock rose. Here’s the reality check I gave him: Your combined position delta tells the whole story. With an ITM covered call, you still participate in about 20-30% of the upside movement, while an OTM position might give you 70-80% participation until the strike price.
Explained in brief – in the case where the share price goes down, if you sell an ITM covered call, you get to keep more of the premium. This helps offset the downside of the long position. In other words, your shares will lose value but you get to pick up more premium, which reduces that loss.
Here’s the example with Apple. If you sold a 9 DTE In The Money covered call, your upside is limited. But you are protected to the downside to the value of $6.35. So even if the shares move down to $233, you will still break even on the position. If we move up, your gains are capped.
One crucial tip I always emphasize: Your strike selection should vary with market conditions. During high volatility periods, I tend to go deeper ITM for more protection. In lower volatility environments, slightly ITM strikes often provide the sweet spot of premium collection and risk management. I’ve got some ideas on how you might want to assess whether to sell ITM, OTM or ATM calls here.
Understanding how covered calls perform in different scenarios is essential for successful options trading. While many traders default to OTM covered calls, consider the compelling benefits of ITM strikes for enhanced downside protection and more predictable returns. Remember: the real risk isn’t to the upside – it’s to the downside, and that’s exactly where ITM covered calls shine.
