What is the poor man’s covered call options strategy?

What is a poor man's covered call?

A poor man’s covered call (PMCC) is an options trading strategy.

Note: for the sake of simplicity, on this page, we’ll focus on PMCCs using equity options (ie options where the underlying asset is a stock), but keep in mind that other types of options are available. Each standard equity options contract represents 100 shares of the underlying stock, and any explanations or examples given will use this as their basis.

A PMCC replicates a covered call position, but without ownership of any stock. With a PMCC, instead of purchasing (and owning) 100 shares of stock, traders buy a long-term, deep in-the-money call option – typically one with an expiration of anywhere from a month to a several months, or even further out.

The PMCC might be particularly appealing to traders with a neutral to bullish outlook on a stock or an exchange-traded fund (ETF). The strategy can be useful to those with less funds available, as it enables you to simulate a covered call with less capital and reduced risk.

The PMCC involves two main components: buying a long-term (back-month) in-the-money call option and selling a short-term (front-month) out-of-the-money call option on the same underlying asset.

Buying a long-term in-the-money (ITM) call option

The long-term ITM call serves as a substitute for actual stock ownership, providing similar directional exposure but at a lower cost. This long call acts as the ‘cover’ for the short call, just as owned shares would in a traditional covered call strategy.

Selling a shorter-term out-of-the-money (OTM) call option

By selling the shorter-term OTM call, traders can reduce the overall cost of the strategy while capping the upside potential. This structure allows for potential profit generation through the collection of premiums from the sold calls.

You’d typically use a PMCC to express a neutral to bullish outlook on an underlying asset. It can be employed to potentially profit from gradual price increases from a relatively stable position. The maximum loss in a PMCC is primarily associated with the long-term call option purchased, similar to how the maximum loss in a traditional covered call is tied to the long stock position.

In a standard covered call strategy, you’d buy stock and then sell a call option to generate a profit. But with a PMCC, you simulate owning the stock by purchasing a long ITM call option, which typically requires less capital compared to buying the stock directly.

How does the poor man's covered call strategy work?

The strategy works by combining the purchase of a long-term ITM call option with the sale of a short-term OTM call option. This structure mimics the risk-reward profile of a traditional covered call but with reduced capital requirements.

To implement the PMCC strategy, you’d start by buying a long-term call option – which, in certain instances, is referred to as a long-term equity anticipation security (LEAP). LEAPS generally have an expiration of one year or more. The LEAP that you’d buy for a PMCC would typically be deep in the money, giving it a high delta, and would provide exposure similar to owning 100 shares of the underlying stock.

Next, you’d sell a shorter-term OTM call option against the long-term call. This short call will generate immediate profit through the premium received. The goal is for this short call to expire worthless, allowing you to keep the full premium.

The PMCC strategy benefits from time decay working in your favour for the short-term option while having less impact on the long-term option. Ideally, if the short call option expires without value, you can keep the premium you received for it and benefit from any gradual increase in the stock price, which would increase the value of the long back-month call option. If the stock price goes above the short call’s strike price, you can profit from the difference in premiums (ie the difference between what you paid for the long call and what you received for the short call) and the appreciation of the long-term call option.

What are the differences between the PMCC and covered call strategies?

The aim of both the PMCC and the traditional covered call is to generate profit, but the two strategies are quite different in terms of how they work and the capital required to trade them.

Traditionally, selling a covered call involves selling an OTM call against 100 shares of stock you own. This strategy can be capital intensive, since you must actually own shares. If the stock price goes above the short call strike price, the owner of the long call can exercise their option at any time until expiration. You’d have to sell your stock at the call strike price, also known as getting ‘called away’. Your shares can also be called away if the short call expires ITM at expiration.

The PMCC uses a long-term ITM call option instead of owned stock. The long call (or LEAP) acts like stock ownership but generally costs a lot less. Instead of paying for shares outright, you’d pay only for the option’s intrinsic value for being in the money and any extrinsic value resulting from time value. Then, you’d sell a shorter-term OTM call against the LEAP to offset any extrinsic value paid for the LEAP, helping to reduce the overall cost of the position.

The PMCC might be more cost-efficient and less risky than a traditional covered call. It lets you create a covered call position with less money upfront, which is great if you have less capital available or want to spread your funds across different positions.

But the PMCC can be a bit trickier to manage, especially when the stock price gets close to or goes above the short call’s strike price. There are many factors that you need to keep in mind – like dividend risk (if the underlying asset pays dividends), hard-to-borrow fees (if there’s high shorting demand) and early assignment. You may also need to adjust positions more often than with a traditional covered call.

How to trade using a PMCC

1. Understand options basics
2. Open a US options and futures account with us
3. Choose an underlying asset
4. Buy a long-term, in-the-money call option
5. Sell a short-term, out-of-the-money call option
6. Monitor and manage the position

What is the profit and loss potential with a PMCC?

The profit and loss potential of a PMCC are determined by the movement of the underlying asset and the behaviour of the options involved. Understanding these dynamics is crucial for effective risk management.

Maximum profit potential:

The maximum profit for a PMCC is realised when the underlying asset’s price closes at or just below the strike price of the short call at expiration. The profit comprises:

1. The premium received from selling the short call
2. The appreciation in value of the long-term call option (LEAP)

The maximum profit can be calculated using the following formula:

Maximum profit = (strike of short call − strike of long LEAP − price of long LEAP + premium received from short call) × 100

For example, consider a stock trading at $200:
Long call (LEAP): buy a $170 strike call expiring in 1 year for $40
Short call: sell a $210 strike call expiring in 30 days for $5

Maximum profit = (210 − 170 − 40 + 5) × 100 = $500

It’s important to note that this calculation assumes the delta of the back-month option is 1, which may not always be the case, especially for options that aren’t deep in the money.

Maximum loss potential:

The maximum loss for a PMCC is primarily associated with the long back-month call option. The worst-case scenario would occur if the stock dropped below the long call’s strike at expiration, causing it to be worthless. The maximum loss can be calculated as:

Maximum loss = cost of long call − premium received from short call

Using the same example:
Maximum loss = ($40 − $5) × 100 = $3,500

Breakeven point:

While the exact breakeven point can’t be calculated due to the differing expiration cycles, it can be estimated as:

Breakeven = long call strike price + net debit paid

Remember, these calculations provide estimates only. Actual profits or losses may vary due to factors such as time decay, changes in implied volatility and early assignment risks.

What happens if a poor man’s covered call is assigned?

If you’re assigned on your short call, you’ll be obligated to sell 100 shares of the underlying stock at the strike price of the short call option. Since you don’t own the stock with a PMCC, you’d end up with 100 shares (per contract) sold at the short call strike price.

It’s worth mentioning that if you get assigned early, you may receive a margin call if there isn’t enough equity in your trading account to maintain the short share assignment.

There are two ways to manage early assignment:

It’s important to quickly address any outstanding margin calls arising from a short share assignment. However, even if you’ve been assigned, as long as you place a covered stock order, your risk will still be defined (ie limited) owing to the long back-month call. Legging out or closing the short shares and long call in two separate orders could increase your maximum loss potential.

Always monitor your positions closely, especially as expiration approaches or if the stock price moves near or above the short call’s strike price. Being prepared for potential assignment scenarios can help you manage your PMCC positions more effectively and mitigate risks.