What Is an Out-of-the-Money Covered Call?
An out-of-the-money (OTM) covered call involves selling a call option with a strike price above the current stock price. This is the most popular form of covered call writing because it allows you to participate in some stock price appreciation while collecting premium income. The option has no intrinsic value and consists entirely of extrinsic (time) value, so the entire premium represents potential income if the option expires worthless.
OTM covered calls are suitable for investors with a moderately bullish outlook who want to generate income without immediately capping their upside. The further out of the money you go, the less premium you receive but the more upside you retain. Finding the right balance between premium income and upside potential is the key skill in OTM covered call writing. Most professional covered call writers use deltas between 0.15 and 0.35 for their OTM strikes.
OTM covered calls let you profit three ways: premium income if the stock stays flat, premium plus capital gains if it rises to the strike, and premium cushion if it drops slightly. Only a significant drop results in a net loss.
Calculating OTM Covered Call Returns
- 1Premium is 100% extrinsic value (no intrinsic value for OTM)
- 2Static return = $1.80 / $98 = 1.84% (in 30 days)
- 3Max profit if called = ($110 - $98 + $1.80) × 100 = $1,380
- 4Max return if called = $1,380 / $9,800 = 14.08%
- 5Breakeven = $98 - $1.80 = $96.20
- 6Upside to strike = ($110 - $100) / $100 = 10%
- 7Annualized if-called return = 14.08% × (365/30) = 171.3%
Choosing the Right OTM Strike Distance
| Distance OTM | Typical Delta | Premium Level | Assignment Probability | Best For |
|---|---|---|---|---|
| 1-3% | 0.40-0.45 | High | ~40-45% | Income focus, less bullish |
| 3-5% | 0.30-0.35 | Moderate | ~30-35% | Balanced income and growth |
| 5-8% | 0.20-0.25 | Low-Moderate | ~20-25% | Growth focus, some income |
| 8-12% | 0.10-0.15 | Low | ~10-15% | Maximum upside, minimal income |
| 12%+ | 0.05-0.10 | Very Low | <10% | Deep OTM hedge, almost no income |
OTM Covered Call Strategies by Market Outlook
Matching Strike to Outlook
Risks of OTM Covered Calls
- Limited downside protection: the smaller premium provides less cushion if the stock drops
- Lower income: OTM premiums are smaller than ATM or ITM premiums
- Opportunity cost if stock rallies well past the strike
- The premium may not justify the risk of capping upside in strong bull markets
- Repeated OTM calls in a flat market may accumulate only modest income
- Transaction costs can eat into small OTM premiums if not using a commission-free broker
Most professional covered call writers find the best risk-reward at 3-5% OTM with 30-45 days to expiration. This zone typically provides the highest annualized return per unit of risk, balancing premium income with upside participation and manageable assignment probability.