Poor Man's Covered Call
A covered call is a trading strategy that allows a person to trade comfortably, minimizing their risks without the necessity of an overly long and complicated strategy.
However, sometimes it will minimize their cash flow to the point where it does not even seem worth making the trade unless they have large volumes of capital.
A poor man's covered call, although slightly more complicated, is very similar but it allows even more people to attempt the principles of a covered call as it does not require as much capital upfront.
Although many refer to it as a poor man's covered call, this is simply a nickname derived from the minimal upfront capital that is required in order to execute the trade. The formal name, although lesser used, is actually a diagonal trade.
The poor man's covered call, as the name implies, is a bullish strategy. The bearish equivalent would be the poor man's covered put, which you can read about here.
It is not really suitable for day trading, but is a slightly more long term strategy. The reason for this is that it will often require the use of long-term equity anticipation securities (LEAPS), which are essentially options that have more than a year until their expiration date.
The reason for LEAPS being preferred is because they are not affected by the same time decay that an option with a closer expiry date might have, and thus minimizes risk.
Before we look at how the poor man's covered call works, let's first look at the difference between it and the regular covered call, and why that makes it so accessible to even those with minimal capital.
Covered Call vs Poor Man's Covered Call
The main difference between the covered call, and the poor man's covered call, is what is traded. When trading a covered call, you may need to invest large quantities of cash upfront in order to ensure that you buy enough of a stock that the profit is worth the time that the covered call takes to execute, which can be anything from a few hours to a few months, depending on your trading strategy and market conditions.
This means that you will have large quantities of capital tied up that you would not be able to use elsewhere. The possible risk, as well as the missed opportunity cost needs to be factored in when entering a covered call.
On the other hand, when entering a poor man's covered call, instead of buying possibly hundreds of shares, you buy LEAPS options.
These options usually represent hundreds of shares, and provide a large potential profit, however they only cost a fraction of the stocks that they represent.
The reason that the trade becomes more complex is also because of the use of options instead of stocks. With the use of options comes new variables, such as the change in the price of the option in relation to the market value of the asset. This can be described using the Greek delta.
Additionally, options are leveraged, which means that, although you do not need to invest as much capital up front in order to enter the trade, you need to be aware that even small differences in the market value will affect your profit more than they would have otherwise. This also adds to the complexity of the poor man's covered call.
This trade off between complexity and price means that the poor man's covered put definitely will not suit everyone's trading style. However, if you are a fairly experienced trader who wants to free up some capital, or you are willing to spend some time learning all the variables of the poor man's covered put and backtesting to confirm your understanding before proceeding, then the strategy can become highly profitable.
How to Use the Poor Man's Covered Call
The Covered Call Concept
In a traditional covered call, you would have to purchase hundreds of shares of a specific stock before you can even begin the trade. This is where the high cost of the covered call occurs because some companies can have shares worth hundreds of dollars, if not more.
After that, you sell a covered call option on those same shares to someone else. The price depends on the market value and the price that you think will ensure profitability. This covered call option is an agreement that you will sell these shares at an agreed upon price at the expiration date. In selling this covered call, you collect a premium.
When the expiration date arrives, there are two possibilities. The first, is that the stock is now worth more than the price that you agreed upon, you are forced to sell the stocks at the cheaper rate.
If the stock price is worth less, the option expires and you get to keep the premium. You can then continue to sell calls and make that premium until you are forced to sell your shares.
This also forms the basis of the wheel strategy which you can read about here.
As long as the premium that you agree to sell at is always higher than the price at which you obtained the stock, you will make some kind of profit.
Thus, you are easily able to minimize your risk. Of course, if the strike price is far higher than the agreed upon rate, you will minimize that profit, but some think that this minimized profit is an acceptable trade off.
The Poor Man's Covered Call
In a poor man's covered call, instead of first purchasing hundreds of shares of a stock upfront, you buy a call option on the stock (Bullish trade). As mentioned above, many prefer to use LEAPS call options to minimize the effects of time decay. Usually, it is best if the option is In-the-Money (ITM).
This would occur when you buy an option where the strike price is below the current market value, leading to an intrinsic value in the option. This option will usually represent the hundreds of shares that you need, but will not cost nearly as much.
Then, you sell a second call option (Bearish trade), with a much closer expiration date. Usually, this is an Out-the Money (OTM) call option.
The idea is to sell this call option very close to the expiration date so that you can make full use of the time decay. The length of time before the expiration date that you want to target will differ based on the type of stock as well as your personal trading style.
Some say about two weeks before expiration is ideal. This sale will also result in a premium, which should cover some of the loss of capital from the first call option, allowing you to continue trading elsewhere and eliminating much of the lost opportunity cost.
There are two possibilities that can occur with the short call option. Firstly, you can close at expiration above the strike price.
In this case, you would have been forced to purchase the shares at the agreed upon strike price. However, because you have the long call option, and the market value is above the strike price, you are able to sell that long option.
Your profit, in this case, would be the difference between the two strikes. Of course, the cost of entering the trades needs to be accounted for.
The second possibility is that the strike price closes lower than the strike price of the short call option, the option expires, and you keep the premium. You are then able to re-enter another short call trade.
Example of Poor Man's Covered Call
In order to better understand the poor man's covered call, let's look at an example with values attached.
First, you need to identify a reasonably stable and predictable, large cap stock. The way that you do this is by analyzing the delta of the stocks.
Some trading platforms or websites will provide this information, but if you prefer to calculate it yourself it can be done using the following equation.
An acceptable delta for entering a poor man's covered call would be somewhere between 0.75 and 0.85. This gives us an indication of the movement of the stock and option prices in relation to one another, as well as the overall risk of the trade.
You purchase a call option for 100 shares of stock XYZ with an expiration date of 400 days at a premium of $10. The strike price is $100, and current market value of the shares is $102.
In this case, you pay the premium of $10, but the $2 profit that you already have in intrinsic value of the shares, for 100 shares, is $200 (potential profit = $190 - transaction fees).
Next, you sell a call option for 100 shares of the same stock with an expiration date of 14 days for a $10 premium. Market value is still $102, and the strike price is $101.
If you close at a market value of $100, the call option expires worthless. The other person does not cash in, and you get to keep the $10 premium in additional profit.
If you close at a market value of $102, the other person will cash in. But, you have a long option with a strike price of $100. So you can buy 100 shares of stock XYZ for $100 each, and then sell those same shares for $101 in order to fulfill the short call option.
Your profit is the $100 plus the premium that you were able to collect from all the times that you reached the expiration date of the short call stock and it expired worthless.
Profit vs Loss Graphs of Poor Man's Covered Call
You always need to be aware of the potential loss of a trade. This can be easily determined through some basic calculations. In some cases, potential profit and loss are theoretically limitless, but when it comes to a poor man's covered call, both are defined.
A graph can be drawn up, such as the one below, allowing you to easily determine at a glance if the trade is worth entering into.
In the case below, we can see that, the higher the stock price gets the more profit is made, until a maximum is reached. The lower the stock price gets, the more the loss, up to a maximum. Of course, the inverse is true for the bearish poor man's covered put.
These graphs can be easily drawn up through the use of specialized software, or simply through the use of an excel spreadsheet. They are also the reason why these trades are referred to as diagonal trades.
In the graph above, it is obvious that the potential loss is about a third of the potential profit. This may be a worthwhile trade for some, while others may think it is not worthwhile.
Advantages of a Poor Man's Covered Call
As mentioned above, the amount of capital that is required to enter into the trades is a lot less than it would have been otherwise. The use of one option in order to cover the risk of the other failing allows you to use your capital elsewhere in the two weeks or more that it takes for you to wait out the second option. This means that even traders who are using smaller, personal accounts are able to make a profit.
If it is done right, then you will have a minimized profit and loss. This means that you will know your risk upfront and you will be able to manage it accurately. Many traders lose most of their money due to poor risk management strategies.
Because of the leveraged nature of the options, you are able to magnify your potential profit even while the use of multiple options mitigate your potential risk.
Disadvantages of a Poor Man's Covered Call
A poor man's covered call, although an extremely useful strategy, is definitely not for everyone.
It can be very difficult for newer traders to grasp the concept and learn how to identify an opportunity for a poor man's covered call. Because of this complexity, they might be more prone to making mistakes. For this reason, it is only recommended that seasoned traders attempt this strategy, or that newer traders who wish to learn spend extensive time backtesting what they believe they understand in order to ensure that they will truly be profitable.
Additionally, the poor man's covered call can take quite a long time to complete. Although it does not consume much capital, it definitely is not ideal for those who wish to day trade, or even swing trade.
It can take months in order to see true profit from the strategy and there may even be additional fees associated with the platforms that swing and day traders prefer to use for keeping the position open overnight.
And, of course, even though risk is mitigated to the point where you know what the maximum risk of the trade is, there is also a maximum profit. Traders can find this extremely frustrating, especially if they have not diversified their portfolio enough. This impatience can lead to mistakes as well.
The problem with making mistakes when it comes to the poor man's covered call is the leveraged nature of options. This can be a big advantage when you enter the trades correctly, but it can also be a big disadvantage if you make even the smallest mistake.
Every loss will be greatly amplified, and if you have decided to attempt the poor man's covered call because you do not have access to a lot of capital then it can be highly detrimental to your account.
Is the Poor Man's Covered Call for You
If you are a trader who is willing to hold a position for more than a few weeks, or even more than a year, then the poor man's covered call is a good way that you can minimize your risk. However, if you are not familiar with options trading, and you are not sure if you have the necessary experience to get the calculations right every time that you enter a new short call option, then perhaps it is better to try the simpler variant of this strategy first.
The covered call strategy might be more capital intensive but it is definitely better suited to beginners.
Additionally, straddle or saddle trades will allow you to practice the basic strategy used to minimize risk while avoiding the use of options entirely. This could also be a good place to start before transitioning into complex options trading strategies.
This will also allow you to become comfortable with the idea of shorting, which some traders do not feel very comfortable with. If you do not yet feel comfortable with the idea of shorting stocks, then do not move on to strategies that require you to short options.
Regardless of whether you decide to attempt the poor man's covered call, or the bearish poor man's covered put, remember that mitigating risk is the key to being a successful trader. All trading comes with a risk. Never trade with more than you are willing to lose.