Sometimes trading can require a high capital amount, so it is not surprising that the poor man’s covered call strategy has collected quite some popularity online. This approach offers a way to use the covered call strategy idea without the need to own the underlying stock, making it an efficient choice for those looking to reduce their cost basis while maintaining a neutral to bullish outlook on their investments. But what is a poor man’s covered call? In this guide, we’ll walk you through how to build this strategy and give you all the tips and tricks you need to increase your profit chances.
Key takeaways
- The poor man’s covered call (PMCC) is very similar to a covered call (you hold stocks and sell a call), but you buy a long-term option instead of shares. It is a more capital-efficient way to simulate the covered call strategy without owning the underlying stock.
- The main idea behind the PMCC strategy is to replicate the benefits of a standard covered call without the high financial commitment that comes from owning the stock.
- The PMCC is used by investors with a neutral to bullish outlook, aiming to reduce cost basis.
What is a Poor Man’s Covered Call?
What is a poor man’s covered call? The Poor Man’s Covered Call (PMCC) is basically an option trading strategy that uses call options to simulate owning stock and selling options but with much less capital outlay. At its core, this strategy consists of two main actions:
- Buying a back-month call option that’s deep in-the-money (acting as a stand-in for the actual stock)
- Selling a shorter-term call option that’s out-of-the-money on the same stock or ETF.
The name simply comes from the fact that instead of owning 100 shares of stock, an investor can use this strategy to create a synthetic position using options with a much lower cost.
Consider this as a quick example: with Amazon (AMZN) trading at $184.72, you could open a PMCC as follows:
- You buy a $130 call expiring in 6 months
- You sell a $210 call expiring in 1 week
Your breakeven point, considering the earliest expiration date (1 week), would be $185.31 (Point A in the P&L profile below). Your profits would stop growing above $220 (Point B), and your losses would bottom below $72 (Point C):
So, why does this matter to you, the investor? With poor man’s covered calls, you’re essentially entering a position that allows for income generation or potential gains from stock price increases without spending large sums of money to own the stock.
The sale of the short-term call will net you a premium, which, in an ideal scenario, you can pocket if the call expires worthless (i.e., the stock price doesn’t exceed the short call’s strike price).
Meanwhile, your back-month call option, purchased for a fraction of the stock’s price, benefits from any increase in the stock’s value, making this strategy cost-effective and potentially profitable.
This strategy is especially appealing for those with a neutral to bullish outlook on a particular stock or ETF. Before we proceed with a more practical approach, we’ll look into how the PMCC differs from the standard covered call strategy.
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The Poor Man’s Covered Call vs a Classic Covered Call
We told you that a PMCC is less costly than a standard covered call, and this is the number one selling point of this strategy. But let’s be a little bit more specific in the table below:
The main idea behind the poor man’s covered call strategy is to replicate the benefits of a classic covered call without the high financial commitment of owning the stock. Instead of purchasing 100 shares for a traditional covered call, you buy a back-month call option, typically a deep in-the-money LEAP, and sell a shorter-term out-of-the-money call option on the same stock.
A LEAP, in case you’re wondering, is a long-term option with an expiration date of one year or more. This type of option will be quite costly, but it will never be as costly as owning 100 shares, and you’ll be able to compensate for this cost with the sold call option premium. You can, of course, buy a call with less than one year to expiry.
Comparatively, the traditional covered call demands significant upfront investment, buying the stock outright, which can tie up a lot of your capital.
In short, here is what you do when setting up a PMCC, compared to a traditional covered call:
- PMCC: Buy one deep ITM and sell one closer-to-the-money, short-term call option on the same stock
- Traditional Covered Call: Own 100 shares of underlying stock and sell one closer-to-the-money short-term call option.
In other words, by selling that shorter-term out-of-the-money call option, you will pocket some cash to add to your account while also avoiding the high capital commitment of owning stock.
A Poor Man’s Covered Call Example
As always, we like to give you examples that can illustrate how an options trading strategy works in real life. Imagine you go to our options screener to find a covered call idea, knowing that you could easily turn it into a PMCC.
For instance, with the “Safe covered calls (Profitable & good companies, growing, high yield, margin of safety)” predefined scan, you may spot a trading opportunity on VF Corp (VFC). As you see below, you could buy 100 shares of VFC (currently trading at $12.59) and sell a $14 call expiring in two weeks:
Suppose, however, that you do not like the idea of owning 100 shares of VFC, and would want to explore cheaper alternatives. A PMCC, in this case, is pretty easy to implement:
- You substitute the shares with a deep ITM call. So, for instance, you could buy a $5 call expiring in 6 months
- You sell the same OTM $14 call just like you would do in the covered call trade idea above.
In terms of P&L, you would obtain a rather similar profile (see image below), but with lower initial capital (note that the graph below only refers to the P&L scenario on the day the short-term call would expire):
This strategy sets up a nice scenario: earn regular income by selling new short-term calls each month while holding a long-term call that benefits from any upward price movement in DAL. Should DAL surge beyond the short-term breakeven price, your net profit is protected by the gains from the long-term call.
The essence of the poor man’s covered calls is in their ability to give you potential income and to let you join a stock bull trend with significantly reduced capital investment.
Pros and Cons of Poor Man’s Covered Calls
After we saw the poor man’s covered call example, we can break down the pros and cons of the PMCC strategy as follows:
Pros
- Capital Efficiency: The strategy allows investors to recreate synthetic covered calls without the high capital needed to own the underlying stock directly. By buying a long-term, in-the-money call instead, you significantly reduce your initial investment.
- Income Potential: Selling short-term, out-of-the-money calls gives you a potentially steady income stream through the premiums collected. If these options expire worthless, you pocket the premium, boosting your overall returns.
- Lower Risk: Compared to owning stocks, the poor man’s covered call strategy presents a reduced risk profile. The premiums received can offset some losses if the stock’s price falls, creating a cushion against market downturns.
Cons
- Limited Upside Potential: While offering income, this strategy also caps your gains. Significant rises in the stock price beyond the strike price of the sold call mean missing out on extra profits.
- Active Management Required: This isn’t a set-and-forget strategy. It needs regular monitoring and decisions on managing the short-term calls as they near expiration, adding a layer of complexity.
- Potential Losses: Despite its advantages, the loss risk is still there. A sharp decline in the underlying stock (perhaps after a major news event or a bad earnings report) could mean the premiums won’t fully cover the losses on your long calls. Remember: this is basically a leveraged position in which you do not own the stocks, you’re using options to speculate on an underlying price movement and, one way or another, you’ll be out of this trade once your options expire.
Profit and Loss Scenarios with the Poor Man’s Covered Call
Before you open a PMCC strategy, make sure you fully understand the profit and loss scenarios that come with it.
For starters, the maximum profit potential in a poor man’s covered call is twofold. Firstly, you pocket the premium from the short call option you sell. Secondly, the long-term call option, or LEAP, appreciates in value from the time you first open the strategy if the stock moves up.
Conversely, the maximum loss scenario is basically the cost of the long call option, minus the premium of the short call. Should the market turn against you, the worst-case scenario sees the LEAP option’s value fall to zero or below the LEAP strike at expiration. Now, of course, this is by definition a rather unlikely scenario (think back to the VFC poor man’s covered call example, currently trading at $12.59 and ask yourself: how likely it is that your 6-month $5 call moves from being deep in-the-money to out-of-the-money?).
It’s worth noting that managing a PMCC requires attention, especially as the stock price nears or surpasses the short call’s strike. Moreover, with American-style options, there’s always the risk of early assignment, potentially leading to unforeseen adjustments in your position.
The Poor Man’s Covered Call vs Poor Man’s Covered Put
It’s not a very popular case, but we should mention that, alongside poor man’s covered calls, a counterpart strategy exists for those with a bearish outlook: the poor man’s covered put. This strategy is essentially a put diagonal debit spread aimed at replicating a covered put position without the high capital and risk usually involved.
We already saw the main traits of the poor man’s covered call: you buy a deep ITM call and sell a near-term OTM call against it. With the poor man’s covered put (PMCP), you buy an ITM put and sell an OTM put against it. The P&L diagram for this strategy is similar to a poor man’s covered call but specular. For instance, performing this strategy on MSFT would give you the following P&L chart:
This is the P&L you’d obtain if you bought a $640 put expiring in over a year and sold a $415 put expiring in one month (consider that MSFT was trading at $425.20 at the time we wrote this article).
On one side, the poor man’s covered put employs a similar logic but inverts the market sentiment. Here, you enter the trade for a debit, and some experts recommend ensuring that this cost doesn’t exceed 75% of the width between the strikes. The strategy involves buying an in-the-money (ITM) put option with a longer expiration and selling an out-of-the-money (OTM) put option with a near-term expiration, as you can easily understand from the MSFT case above.
This structure provides a safety net against the naked short stock component present in a standard covered put, thereby making it a much safer and capital-efficient strategy.
Both strategies share the commonality of being entered for a debit and leveraging the time decay of short-term options to the trader’s advantage. However, they correspond to different market outlooks, with the poor man’s covered calls designed for those bullish on a stock, while the poor man’s covered put suits those who anticipate a decline.
In simple terms, let us summarize the different between these two strategies below:
When Do You Want to Use a Poor Man’s Covered Call?
It may be implicit in the text above, but we’d like to clarify once and for all when exactly you’d want to employ a poor man’s covered call (PMCC). This strategy is ideal for investors who have a neutral to bullish outlook on a specific stock or ETF.
When you choose a PMCC, you’re essentially reducing the cost basis on your long call through the sale of a short call. The target scenario here is for the short call option to expire worthless, allowing you to pocket the premium while hopefully watching the price of the underlying stock climb in the long run. This increase in stock price, in turn, pushes up the value of your long, out-month call option.
Keep in mind that the main pro of a PMCC is its ability to let you participate in potential stock price appreciation with significantly less capital compared to outright stock purchases. It’s a way for those looking to generate additional income or for those bullish on a stock but not bullish enough to employ a high capital for over a year.
What Could Happen after Opening a Poor Man’s Covered Call Strategy
Before wrapping up, let’s take a moment to consider what may happen after opening a poor man’s covered call strategy. This strategy, while capital-efficient and potentially profitable, carries various outcomes based on the stock’s performance.
In the best-case scenario, a PMCC will be closed for a winner if the stock price surges within one expiration cycle. As the stock price climbs, the call options involved in your PMCC start trading close to their intrinsic value (remember: the extrinsic value will always move down to zero by the time your options reach expiration).
Consequently, the profit potential from the trade begins to move lower, which can give you an ideal exit point. This situation is what every investor hopes for – a significant increase in stock value leading to a profitable closure of their PMCC.
However, let’s be realistic: not all trades will give you easy profits. If the stock price takes a downturn, you’ll need to reassess your trade. Here is what you could do: the short call option, which is part of your strategy, can be rolled to a lower strike. If you do so, you collect more credit, potentially offsetting some of the losses from the decrease in stock price. We told you before that this trade requires constant monitoring, and the rolling operation is just a practical example of it.
It’s essential to actively manage your PMCC, especially as the expiration date for the short-term call nears. Decisions need to be made—whether to let the short call expire, buy it back, or roll it over to a new date or strike. Be aware of the risk of early assignment, particularly if the stock price escalates well above the strike of the short-term call.
