Ultimate Guide to the Poor Man’s Covered Call
What’s a poor man’s covered call? You may be more familiar with the strategy it replicates, called a covered call. A covered call is basically selling call options on a stock you own for extra income (but limits your profits). While covered calls are great, they can be expensive. Not everyone has the capital to purchase enough shares of a stock to sell covered calls.
This is where the poor man’s covered call comes in. The poor man’s covered call is a lesser-known variation of the traditional covered call. It is a technique used to imitate the profits of a traditional call without the necessity of a large upfront investment in 100 shares of underlying stock. This strategy potentially compliments a LEAP option strategy.
The poor man’s covered call may not be as well known as the traditional covered call, but it can also generate income for less capital upfront. If you are unfamiliar with both a covered call and a poor man’s covered call, fret not! This article will go over the mechanics of both so you can understand how to utilize this strategy.
What is a Poor Man’s Covered Call
The poor man’s covered call uses a call option instead of the underlying stock to replicate a traditional covered call strategy. As its name would suggest, it requires less upfront capital to execute. To understand the mechanics of the poor man’s covered call, let’s first review the traditional covered call first.
What is a Covered Call
A call option in the United States is the right, but not the obligation, to buy 100 shares of an underlying stock for a certain price (the strike price). A covered call generally involves buying at least 100 shares of a stock and selling a call option for the same stock.
By selling a covered call, you are effectively selling the right for someone to buy your shares at a strike price you determine by an agreed upon date (expiration date). In exchange, the buyer pays you a premium for this right.
Example: Imagine that you hold 100 shares of XYZ stock at $10 per share, a $1,000 investment. You believe that in the long-term XYZ stock will rise, so you don’t want to exit your position. However, you believe that before the next earnings XYZ stock will trade sideways. You are also OK with selling your XYZ stock if it hits $12 within the next three months.
Therefore, you write a covered call with a strike price $12 and an expiration date three months out. The call option premium is $0.5 per share, or $50 since each option contract is for 100 shares. This premium is paid by the buyer who now has the right to purchase your 100 shares at $12 should XYZ stock go above the strike price.
This will also lower your cost basis because you have now basically paid $950 for 100 shares, rather than $1,000 (by making a $50 profit from the premium).
Calculating Profits of a Covered Call
Below is how you calculate the various scenarios for your covered call strategy in this example.
Maximum Profit: If XYZ stock goes above $12, you will be obligated to sell your 100 shares at $12 a share, or $1,200. Your max profit in this case would be $250:
$1,200 (sale price) + $50 (premium from selling call option) = $1,250
$1,250 – $1,000 (purchase price) = $250
Breakeven: Your breakeven is now $9.50 per share instead of $10 a share because of receiving a premium of $0.50 per share from selling a call option.
Maximum Loss: In the unexpected event that the share price dropped to $0, your maximum loss would be $950 because you’ve received a $50 premium from selling the call option.
What is a Poor Man’s Covered Call (Long Diagonal Spread)
For those that don’t want to tie up capital to buy 100 shares of the underlying stock, there is the poor man’s covered call.
To understand this, let’s first review a few concepts:
- In-the-Money (ITM) — When a call options contract is ITM, it has a strike price that is lower than the market price of the underlying stock.
- Out-of-the-Money (OTM) — When a call options contract is OTM, it has a strike price that is higher than the market price of the underlying stock.
- Being Long a Call Option — An investor is considered long a call option when they purchase a call option expecting the underlying asset to increase in value.
- Being Short a Call Option — An investor is considered short a call option when they sell a call option with the intention of repurchasing it, or covering it at a lower price later. This is typically done when the trader believes that the price of the stock will decrease.
The poor man’s covered call circumvents the need to purchase and hold 100 underlying shares of stock by instead purchasing a long call option that is ITM. Just like the covered call, the trader then sells an OTM call option, but at an earlier expiration than the ITM call option.
Because your long option expires later and is ITM, it will technically always have equal or greater value than the OTM option that you short. In theory, you’ll always be able to liquidate your long option to cover any losses from your short option (although there could be execution risk).
Let’s look at a real world example.
Calculating Your Winnings & Losses
Since it can get technical thinking about your profits and losses, we will go over an example below using a real stock.
Real World Example of Poor Man’s Covered Call
If we wanted to do a regular covered call strategy for Tesla, Inc. (Nasdaq: TSLA), we would have to buy 100 shares, or over $90,000 of an initial capital outlay as of January 25, 2022. But our initial outlay would be lower using a poor man’s covered call. Let’s look at the details below.
Remember, you must first determine to buy (long) an option that is in-the-money. First, let’s look at the TSLA options chain below for options expiring March 18, 2022 as our long chain. If we buy one contract with a strike price of $800, our initial outlay will be about $17,805 ($178.05 x 100 using the ask price).
The next step is shorting a call option — it should be out-of-the money and have a shorter expiration date. Let’s pick a $1,000 strike price expiring February 4, 2022.
We can sell it for $3,325 using the ask price. Our initial cash outlay is what we paid for our long call minus what we received from the short call. This would be in the example $17,805 – $3,325 = $14,480.
Now let’s see how we can calculate our potential profits and losses.
Calculating Your Maximum Profits
Please note that in order to simplify calculations below – we won’t be taking into account any extrinsic value. This is to exclude calculating factors that’ll impact extrinsic value such as time decay, change in interest rates, or change in volatility of the underlying stock.
Maximum profits can be estimated by the difference between the strike price of your short option and long option minus your initial cash outlay:
Strike price of short option – Strike price of long option – Initial cash outlay
In our example above, maximum profit is: $1,000 – $800 – $144.8 = $55.20. We then multiply it by 100 (each option is for 100 shares) and get $5,520.
Using our example, let’s say Tesla’s stock price hits $1,000. The long call option will have $200 of intrinsic value. The short option will have an intrinsic value of $0:
$200 – $0 – $144.8 = $55.20.
$55.20 x 100 = $5,520.
Calculating Your Breakeven
The breakeven price of the stock for your poor man’s covered call is typically:
Strike price of long option + Initial cash outlay
So in our example above, your break even point would be $800+ $144.8 = $944.80
Calculating Your Maximum Loss
Your maximum loss would be your initial net cash outlay of $178.05 – $33.25 = $144.8. $144.8 x 100 = $14,480.
Simply stated, if Tesla stock fell to $800 or below, both your long call option and short call option would be worthless and you’d lose your initial cash outlay of $14,480.
Pros and Cons of a Poor Man’s Covered Call
Now that you understand how to implement a poor man’s covered call. Let’s review the pros and cons of this trading tactic.
- Less Initial Capital Outlay — You don’t have to lock up capital in 100 shares of underlying stock to employ the poor man’s covered call strategy.
- Higher Max Profit as a % — While maximum profits are typically lower, your profits as a percentage of your initial capital outlay may be higher than they would be with a traditional covered call.
- Leverage — using options instead of actual shares means all of your capital is at risk even if the underlying stock doesn’t drop to $0. In our example above, if Tesla’s stock price is $800 or below, your options would have no intrinsic value.
- More Complex — You have to decide on an expiration date and strike price for your long option and also make sure your short option has a shorter expiration and has a higher strike price than your long option.
- No Dividends — Holding 100 shares of the underlying stock may give you access to dividends which you can reinvest. Options contracts do not pay dividends.
- Execution Risk — Technically if the option you shorted is called, your broker knows to liquidate your long option position to cover your short position. But you could still be exposed to execution risk (i.e. price fluctuations between the time you liquidate long and short call options).
The poor man’s covered call is a great tool for the investor that doesn’t want to lock up their capital in large positions, or simply doesn’t have the capital to participate in a traditional covered call strategy.
However, the poor man’s covered call comes with risks. As with most option plays, you could lose your whole investment despite a modest decline in the underlying stock. It is vital that you do your due diligence before you dive into this strategy. However, if used correctly, the poor man’s covered call will be a nice addition to your investment arsenal. Happy investing!
Disclaimer: The content presented is for informational purposes only and does not constitute financial, investment, tax, legal, or professional advice. If any securities were mentioned in the content, the author may hold positions in the mentioned securities. The content is provided ‘as is’ without any representations or warranties, express or implied.