The poor man’s covered call is a strategy designed to benefit from a covered call strategy without the need to own the underlying stock. Using a long-term in-the-money (ITM) call option, known as a LEAPS Option, is used as a substitute for stock ownership. Since the initial capital needed to purchase the underlying stock can be substantial, this is what makes the poor man’s covered call a great option.
The Basics Of A Poor Man’s Covered Call
The poor man’s covered call is an options strategy that replicates the income-generating potential of a traditional covered call. Instead of owning the stock, you can purchase a long-term in-the-money (ITM) call option. You can then sell short-term out-of-the-money (OTM) call options against the long-term call option, generating premium income and providing some downside protection.
Comparison With Traditional Covered Calls
Both traditional and poor man’s covered calls involve selling call options to generate income. In a traditional covered call, you own the underlying stock, while in a poor man’s covered call, you own a long-term call option instead. The initial capital required for a poor man’s covered call is typically lower than for a traditional covered call, making it more accessible with limited funds.
Advantages Of Using A Poor Man’s Covered Call
- Lower upfront cost: Purchasing a long-term call option instead of the underlying stock makes the initial investment is lower.
- Income generation: Generate income by selling short-term call options against the long-term call option, similar to a traditional covered call.
- Leverage: The use of a long-term call option provides leverage, magnifying potential gains if the underlying stock moves in the desired direction.
- Limited risk: The maximum loss is limited to the cost of the long-term call option, protecting against significant losses in case the stock price declines.
Risks And Limitations Of A Poor Man’s Covered Call
- Limited upside potential: Selling short-term call options caps the potential gains from the underlying stock’s appreciation. If the stock price rises significantly above the strike price of the short-term call option, you can miss out on additional profits.
- Risk of early assignment: If the short-term call option becomes in the money and is approaching expiration, there is a risk of early assignment, where the option buyer exercises the option. In the case of early assignment, you may need to sell your leap option to cover the exercised short-term call, potentially resulting in a loss or lower-than-expected gains.
- The impact of time decay on LEAPS options: While LEAPS options have a longer expiration date, reducing the impact of time decay, they are still susceptible to losing value as they approach expiration. If the underlying stock fails to appreciate in value, the LEAPS option may lose value over time, resulting in a potential loss.
Examples Of A Poor Man’s Covered Call
Successful Usage Of Poor Man’s Covered Call
- Identify a stable, growing stock with strong fundamentals and sufficient options liquidity.
- Purchase a LEAPS option on the chosen stock with a delta of 0.80 and an expiration date 18 months away, spending considerably less than buying the stock outright.
- Sell a short-term OTM call option on the chosen stock, generating premium income and providing downside protection.
- As the short-term call option approaches expiration, it remains OTM, and you then sell another short-term call option, continuing to generate premium income.
- Over time, the underlying stock appreciates in value, increasing the value of the LEAPS option, and successfully generate income and profits from the poor man’s covered call strategy.
Unsuccessful Usage Of Poor Man’s Covered Call
- Choose a stock with high volatility and weak fundamentals, hoping to capitalize on higher option premiums.
- Purchase a LEAPS option on chosen stock and sells a short-term OTM call option to generate premium income.
- The stock experiences a significant price increase, causing the short-term call option to become ITM, and face the risk of early assignment.
- To avoid early assignment, you buy back the short-term call option at a higher price, resulting in a net loss for that position.
- The stock price subsequently declines, reducing the value of the LEAPS option and leading to overall underperformance of the poor man’s covered call strategy.
Lessons Learned From The Examples
Stock selection is important for the success of the poor man’s covered call strategy. You should choose stable, growing stocks with strong fundamentals and sufficient options liquidity. The potential for higher premiums from volatile stocks may be outweighed by the increased risk of early assignment and fluctuations in the value of the LEAPS option.
If you have limited capital or are seeking to generate income while maintaining some downside protection, the poor man’s covered call can be an attractive alternative to a traditional covered call strategy. You must carefully consider the risks and limitations of this strategy, including limited upside potential, the risk of early assignment, and the impact of time decay on LEAPS options.