What is a Poor Man's Covered Put?
Before we can decide if it is for us, we first need to answer the question, 'What is a Poor Man's Covered Put?"
Firstly, the poor man's covered put is a bearish strategy that is used to trade options. It is similar to the easy-to-understand covered put strategy, but uses far less capital overall while still allowing risk to be defined.
This is a long-term strategy that most often involves the use of long-term equity anticipation securities (LEAPS), which are options with more than 365 days remaining until their expiration date.
Although the use of LEAPS is not required for a poor man's covered put, it is preferred by a variety of traders due to the fact that it is not as affected by accelerated time decay(Theta). This is when the value of an option plummets closer to the expiration date due to the fact that there is less time to realize profits from the option.
The fact that only a single option is bought instead of hundreds of shares in a stock is one of the many reasons why the poor man's covered put it so appealing to many.One of the most important numbers when it comes to the poor man's covered put is delta, which is a measure of how much the price of an option changes in relation to market value of the asset that it represents.
How to Use a Poor Man's Covered Put
Now that we have answered the question, 'What is the poor man's covered put?' we can look at how to use it for our own benefit.
First, any option that is being traded needs to have some intrinsic value. This means that the strike price and the market value need to differ slightly.
The best scenario for a poor man's covered put is when you can buy the option at a strike price that is above the market value. Meaning that profit occurs almost instantaneously with the exclusion of fees.
This is called an In-The-Money price. The alternative to this would be an Out-The-Money price, which means that the strike price is not favorable in relation to the market value.
Once it is determined that the option has intrinsic value, and that the strike price is higher than the market value, a person can buy an In-The-Money put option.
However, now there is a great loss in terms of capital, so in order to cover that, a person sells an Out-The-Money (strike price lower than market value) put option with a shorter expiration date.
This means that regardless of which way the value of the option moves, there is always a maximum profit or loss, until the first expiration date is reached.
Example of Poor Man's Covered Put
The first step is to choose an asset or stock. Because of the fact that this is a long-term trading strategy it is best to avoid the use of penny stocks or even mid-volume stocks.
High volume stocks are the best. For this example, we will be looking at Coca-Cola.
To calculate the delta value, we will require a simple equation.
A good delta would be somewhere between 0.75 and 0.85. Afterwards we can confirm if the strike price of the put option is higher than the market value.
Let's say, theoretically, the values are as follows:
The market value of the option is $62, and the strike price for the put option is $63. This means that, upon buying it, a profit is already generated. But, in order to account for the change in capital, the same put option has to be sold. This will immediately reduce the profit that has already been earned, however, it will also allow a person to mitigate risk.
If the put option is not sold (bullish trade) and the stock price rises, then you will lose money. It is possible to wait out the loss for some time, but it is not always guaranteed that the price will come back down and therefore cover your loss, instead the loss may only continue to grow.
The selling of the put option will reduce the amount of profit that is made as the price drops however, and this is important to keep in mind. It can be helpful to draw out a profit/loss chart such as the one below.
This can be done with a variety of software, or it can simply be done using excel spreadsheets. This is known as a diagonal spread and should take into account for the cumulative profit and loss of both the bought and the sold put options.
This example is ridiculously oversimplified, so it is important to remember that regular situations would be a lot more difficult to.
Advantage of a Poor Man's Covered Put
Because of the reduced amount of capital required, it is far easier to trade a poor man's covered put in large quantities, and potentially make larger profits, than it is to trade a simple covered put.
This means that it is more accessible to traders who do not necessarily have large quantities of money at their disposal.
Compared to the regular covered put, both involve shorting an option, which has endless potentials for loss as the price can theoretically rise infinitely. The poor man's covered put, however, allows a person to dictate, and mitigate the risk that is associated with shorting.
Additionally, because the position is leveraged, i.e. one option is representative of more than one stock, it becomes increasingly capital efficient and a person might even be able to buy an option representing 100 stocks for less than the price of a single stock.
Disadvantages of a Poor Man's Covered Put
The poor man's covered put can be quite difficult for newer, and even seasoned traders to understand at first.
For this reason it can be easy to make mistakes or to misunderstand the strategy, leading to an increased occurrence of mistakes and a potential loss.
The poor man's covered put is not suitable for day trading or even swing trading, but can only be utilized optimally for more long term trades, such as several weeks or even more than a year.
Additionally, even though some risk is mitigated due to the use of a bought and sold put option, all losses and profits are magnified largely due to the fact that most options are leveraged positions.
Is the Poor Man's Covered Put for You?
Because the poor man's covered put uses so much less capital, while at the same time allowing for the mitigation of risk, it would be far superior to the use of the regular covered put for experienced traders with slightly larger portfolios but not enough cash on hand to buy hundreds of each share that they wish to invest in.
However, because the poor man's covered put is significantly more complex than the regular covered put and makes use of complex figures such as delta, it is not recommended for beginners.
All good traders should be able to profit in both a bearish and a bullish market. This strategy can be utilized in both markets as well. The opposite of a poor man's covered put is referred to as a poor man's covered call and works exactly the same way. This method could also be ideal for traders who wish to bearish trades due to being unfamiliar with them.
Regardless of whether you decide if the poor man's covered put is for you, it is always important to mitigate risk, and trade responsibility.