Downturn Survival Notebook, Vol. 3: Why Covered Call is the Most Common Hedging

In the previous post, we discussed using long puts for deep hedging. But as mentioned, the scenarios that truly call for long-put hedges are typically panic-driven sell-offs—they don’t happen that often. Statistically, over the past ten years, they’ve occurred about once per year on average, and in some years they don’t occur at all.

By contrast, milder, more contained pullbacks happen many times every year. These types of declines are not ideal for using “heavy weapons” like put options to hedge—especially from a technical-analysis perspective, because by the time hedging signals are triggered, the market is often already close to a rebound.

Therefore, for mild and limited drawdown, the most suitable strategy is the Covered Call Strategy.

Before we begin today’s topic, here’s a quick quiz:

A covered call is a type of short call—specifically, a short call backed by an existing stock position. It is different from a naked short call. Naked short calls are extremely high-risk strategies and typically require a large amount of margin. By contrast, because a covered call is backed by shares, it generally does not require additional margin, and it does not carry the same “blow-up” risk profile.

For a stock-backed covered call setup, the expiration is typically 3–4 months or shorter. There are two main ways to choose the strike price:

If the investor is temporarily “stuck” in the position (underwater), they can set the strike at the cost basis (break-even level).

Alternatively, the strike can be set 30%–50% above the current price (depending on the stock’s IV—the higher the IV, the more room you should leave). This approach works whether the investor is underwater or not.

Note that stocks with too low IVs are not suitable for covered calls. Due to low IV, the premium collected would be small, especially compared with the upward potential of stock price. Generally, 35 is a common boudary for short side trades. For the covered call strategy to work well, IV of 40 or plus would be ideal.

Note that while a stock-backed covered call does not have blow-up risk and may look “safe” on paper, it does have opportunity risk. If the stock rises too quickly and the option is exercised before expiration, the investor may be forced to deliver the shares to the call buyer—potentially missing further upside in the stock.

To reduce this risk:

(1) Avoid using covered calls when the stock appears to be near a valuation bottom (often referred to as “selling calls at the bottom”).

(2) Do not set the strike too close to the current price—leave a sufficiently wide safety buffer.

Assume Stock A was heavily bid up to 300 earlier this year and then began a prolonged decline. An investor “bought the dip” at 200, only to see the stock fall further to 100. However, the investor still believes in the company’s long-term prospects, so they decide to use a short-call approach to collect premium and reduce their effective cost.

Assume it is now December. Following the “no longer than 3–4 months” rule, the investor chooses an option expiring in March next year. For the strike, the cost basis of 200 is far above the current price, which would result in too little premium. Therefore, the investor uses the “30%–50% above spot” rule and sets the strike at 140 (40% above the current price).

Assume the option premium is 4.

A simple way to estimate the return is to divide premium by the strike:4 / 140 = 2.8%.

This is the return over roughly four months. Annualized, it would be approximately 8.4%.

After establishing a short-call position, there are generally two follow-up approaches:

(1) Hold to expiration, or

(2) Close early.

In many cases, closing early can help the investor realize the premium faster. After closing, the investor should reassess market conditions:

– If the stock is not in a sustained uptrend, they can continue to reopen the strategy and repeat.

– If the stock is about to rally or is already trending higher, it may be better to wait for a more suitable moment before selling calls again.

In short, adding some discretionary timing can make the trade management more intelligent.

Finally, let’s compare the two hedging tools we’ve covered—protective puts and covered calls. Although both can be viewed as “hedging tools,” they solve very different problems. Protective puts are designed for sharp, violent downside moves triggered by panic selling, while covered calls are better suited to the market’s normal fluctuations and more natural pullbacks.

When you use protective puts, you pay premium (insurance cost) in exchange for explicit downside protection. If the market experiences panic selling or a rapid, deep drop, long puts can become much more protective and help “stop the bleeding” during large drawdowns. The trade-off is that if the market is only mildly correcting or moving sideways, the put’s time value will keep decaying—making it an expensive tool if used too frequently. And from a signal perspective, it’s common for hedging signals to trigger near short-term sentiment lows, which can lead to the awkward outcome of “buying protection right before a rebound.”

By contrast, with a covered call, you receive premium (rent) to enhance returns and reduce your effective cost basis, providing a cushion for your position. It is more suitable for mild pullbacks, choppy downtrends, and weak rebounds—improving holding efficiency without selling the stock. However, it is not true “downside insurance.” In a fast crash, the premium can only offset a small portion of losses. And it introduces opportunity cost: if the stock rallies sharply, you may be assigned and miss further upside.