If you're familiar with covered calls but are looking for a way to maximize your capital efficiency, you might have come across the strategy called the "poor man's covered call." This clever options trading strategy allows investors to mimic the benefits of a covered call while tying up significantly less capital. While it’s a versatile and potentially lucrative strategy, understanding its nuances is critical to making it work effectively. In this post, we’ll dive deep into poor man’s covered calls, exploring their mechanics, pros and cons, the best stocks for this approach, and essential considerations for success.
What Is a Poor Man’s Covered Call?
A poor man’s covered call is a variation of the traditional covered call strategy. Instead of owning the underlying stock, you purchase a deep in-the-money (ITM) long-term call option (known as a LEAPS option) and then sell a shorter-term out-of-the-money (OTM) call option against it. This setup mimics the risk/reward profile of a covered call while requiring far less initial capital.
The key is the deep ITM LEAPS call, which acts as a surrogate for owning the stock. These options have high delta—often above 0.8—meaning their price moves similarly to the underlying stock. However, because they cost significantly less than buying the stock outright, you free up capital for other investments or to execute multiple poor man’s covered call trades.
How Poor Man’s Covered Calls Work
To implement this strategy:
Buy a LEAPS Call Option: Select a deep ITM call option with an expiration date at least six months to a year (or more) in the future. The longer the expiration, the more time you have to execute multiple short-term trades against it.
Sell a Short-Term Call Option: Choose an OTM call option with an expiration date much closer—typically 30-45 days out. Selling this call generates premium income, which is the primary source of profits in this strategy.
The profit potential lies in the premium collected from the short-term call. If the stock price remains below the strike price of the short-term call by expiration, the option expires worthless, and you keep the premium. If the stock rises slightly but remains under the strike price, you also benefit from the LEAPS appreciating in value.
Simple Example of a Poor Man’s Covered Call
Let’s say Apple Inc. (AAPL) is trading at $180 per share, and you want to use a poor man’s covered call instead of buying 100 shares (which would cost $18,000).
Step 1: Buy a LEAPS Call Option
Buy a long-term, deep in-the-money (ITM) call option.
Example: Buy an AAPL January 2025 $120 Call for $6,500.
This acts as a substitute for owning the stock but costs much less.
Step 2: Sell a Short-Term Call Option
Sell a short-term, out-of-the-money (OTM) call option to generate income.
Example: Sell an AAPL December 2024 $190 Call for $300.
You collect this premium upfront.
Possible Outcomes
Stock Stays Below $190 (Best Case):
The short-term call expires worthless.
You keep the $300 premium and can sell another call next month.
Stock Rises Above $190 (Assignment):
Your short-term call is assigned, and you "sell" at $190.
Your LEAPS call covers the assignment, and you still make a profit.
Stock Drops Below $180:
The short-term call expires worthless (you keep $300).
The LEAPS call loses some value, but you can hold it for recovery or sell it.
The Pros of Poor Man’s Covered Calls
Lower Capital Requirements: Traditional covered calls require owning 100 shares of a stock, which can be prohibitively expensive for high-priced stocks like Tesla or Amazon. A poor man’s covered call eliminates this hurdle by leveraging LEAPS options.
Enhanced ROI: By investing less capital upfront, you can achieve a higher percentage return on investment compared to traditional covered calls.
Diversification: With less capital tied up in each position, you can spread your investments across multiple stocks or sectors, reducing portfolio risk.
Ongoing Income: Like regular covered calls, this strategy generates consistent income from selling short-term calls, making it ideal for traders seeking cash flow.
Flexibility: If the underlying stock price significantly increases, you can roll the short-term call to a higher strike price, capturing more upside.
The Cons of Poor Man’s Covered Calls
Complexity: Poor man’s covered calls require a deeper understanding of options pricing and behavior. Unlike owning stock, LEAPS options can lose value due to time decay (theta).
Implied Volatility Risks: The value of your LEAPS can fluctuate based on changes in implied volatility, independent of the stock's price movement. This can introduce additional risks.
Limited Upside: Like traditional covered calls, this strategy caps your profit potential at the strike price of the short-term call. If the stock makes a significant upward move, your gains are limited.
Liquidity Concerns: Not all stocks have liquid options markets, particularly for LEAPS. Wide bid-ask spreads can eat into profits.
Assignment Risk: If the stock price exceeds the strike price of the short-term call, you may be assigned early. While this isn’t always a bad outcome, it requires you to manage the position actively.
Best Types of Stocks for Poor Man’s Covered Calls
The success of this strategy hinges on selecting the right stocks. Here are a few key criteria to consider:
High Liquidity: Choose stocks with active options markets and narrow bid-ask spreads to minimize trading costs.
Stable or Gradually Upward Trending Stocks: Since the strategy works best when the stock price remains below the strike price of the short-term call, look for companies with steady, predictable performance.
Moderate Volatility: Stocks with moderate implied volatility provide a good balance between premium income and risk. High volatility stocks may offer higher premiums but come with increased risk of large price swings.
Blue-Chip or Dividend-Paying Stocks: Reliable, well-established companies often have stable stock prices and liquid options markets, making them ideal candidates.
Practical Tips for Implementing Poor Man’s Covered Calls
Use the Delta Rule for LEAPS Selection: Aim for a LEAPS call with a delta of at least 0.8. This ensures your option closely tracks the stock price and behaves similarly to owning the shares.
Optimize Short-Term Call Expirations: Selling calls with 30-45 days to expiration strikes a balance between premium decay and rolling opportunities.
Monitor Volatility: Be aware of changes in implied volatility, especially during earnings season or market turmoil. High volatility increases the premium but also the risk of large price swings.
Have an Exit Plan: Know when to close, roll, or adjust your position. If the stock price breaches the short-term call’s strike price, consider rolling the option to a higher strike or longer expiration.
Start Small: If you’re new to this strategy, experiment with smaller positions before committing significant capital.
Is a Poor Man’s Covered Call Right for You?
Poor man’s covered calls are an innovative way to generate consistent income while conserving capital. However, they require a solid understanding of options mechanics and active management to mitigate risks. If you’re willing to invest the time to learn and monitor your positions, this strategy can be a powerful addition to your investment toolkit.
By carefully selecting stocks, balancing risks, and optimizing your trades, poor man’s covered calls can help you unlock new levels of income and growth potential in your portfolio. Whether you’re a seasoned options trader or looking to graduate from simpler strategies, this approach is worth exploring.
Feel free to share your experiences or ask questions about poor man’s covered calls in the comments below. And don’t forget to subscribe to ProfitOnTheStreet for more actionable investment insights!
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