The poor man’s covered call is an options strategy in which you can participate in a covered call without having to put up the cash to purchase 100 shares of stock. As most traders know, covered calls are a great way to collect options premium as well as enjoy price appreciation in the stock. The problem is that they can be quite expensive to get into since they require you to have enough cash to purchase 100 shares of the underlying. Let’s take a look at how the poor man’s covered call works and the optimal way to trade it.
Summary
- The poor man’s covered call is an alternative way to clone a covered call without being subject to the capital requirements involved with a traditional covered call
- It is commonly referred to as a “long call diagonal debit spread” and entered into with a net debit
- This strategy is done when a trader is bullish on the price of the stock and the implied volatility environment is low
- The strategy benefits from an expansion in implied volatility
What is a Poor Man’s Covered Call?
A poor man’s covered call is an options strategy that is used to clone a covered call. This strategy gets its name because of the reduced capital required to mimic a covered call. If you’re familiar with covered calls, you know that they require you to purchase 100 shares of the underlying and sell an out-of-the-money call option.
The poor man’s covered call is also commonly known as a “long call diagonal debit spread”. The strategy is done by buying an in-the-money call option with a longer expiration date and selling an out-of-the-money call option with a shorter expiration date. It is considered a bullish strategy that is best done in a low implied volatility environment
So, rather than buying 100 shares of stock, a “poor” investor would buy an ITM call with a longer expiration schedule and sell an OTM call with a shorter expiration schedule. Selling the out-of-the-money call reduces your overall cost basis and helps you make up some of the theta decay from the long call option. This strategy is essentially a combination of a calendar spread and a vertical spread.
Poor Mans Covered Call Construction
The poor man’s covered call is entered into with a net debit and it consists of the following two contracts below.
- Buying an in-the-money (ITM) call option with a longer expiration cycle
- Selling an out-of-the-money(OTM) call option with a shorter expiration cycle
Generally, it is recommended that the net debit paid for the trade is not greater than 75% of the width of the two strikes.
Poor Man’s Covered Call Example
Let’s assume that Apple (AAPL) stock is currently trading at $150 per share and you are bullish on the price of the stock for the next 90 days. As a result, you decide to enter into a poor man’s covered call and purchase a June $140 call option and sell a May $155 call option.
| Example Scanario | AAPL is trading at $150 per share 90 days to June expiration |
| The Trade | Buy June $140 call option @ $7.00 – 90 days out Sell May $155 call option @$2.50 30 days out |
| Net Debit | $4.50 |
Trade Breakdown: The long call option at $140 is $10 in-the-money and the short call option at $155 is $5 out-of-the-money. The net debit cost associated with this trade is $4.50.
Profit potential = The exact amount can’t be calculated due to different expiration cycles and also the change in implied volatility throughout the cycle of the expiration.
Break-even price = Also unknown due to the different expiration dates and change in implied volatility.
Max loss amount = Limited to the Debit Amount Paid
Max loss amount = $450
As you can see, this trade follows the recommended rule that the net debit paid for the trade is not more than 75% of the width of the two strikes.
Width of the strikes = $155 – $140 = $15.00
Net debit = $4.50
Check = $4.50/$15.00 = 30%
Recommended Rules For a Poor Man’s Covered Call
Rule for Long Call
Delta = Greater than or Equal to .75
Days to expiration = Minimum of 60
When doing a poor man’s covered call it is recommended that your long call option has a delta of at least .75 or higher. This way for every dollar move in in the underlying you will gain more on your call option. We also recommend that your long call is at least 60 days out until expiration. This will give you enough time to experience an increase in implied volatility.
Rule for Short Call
Net Debit = The net debit paid for the trade is not more than 75% of the width of the two strikes
This ensures that the net debit paid isn’t too high compared to the distance of the two strikes prices. Since your net debit cost is your maximum possible loss on this trade, you don’t want the amount to significant in case the stock moves sharply against you early on in the expiration.
How to Manage A Poor Man’s Covered Call
It’s important to know how to manage your poor man’s covered call position as the expiration date approaches and the price of the stock changes. Throughout the life of the trade, the implied volatility, premium, and profitability of the trade will change. As a result, you have to be prepared to manage the trade if it goes in your favor or against you.
When To Close a Poor Man’s Covered Call
If the price of the stock rises significantly, or above your short call strike price, you can close both legs of the trade and collect all your profit. In the best-case scenario, this will happen early on in the trade or in the first expiration cycle. The earlier it happens the more intrinsic value your long call option will make and subsequently the larger your profit will be.
Managing Your Trade
If the price of the stock slides to the downside, the short call strike price can be closed and rolled down to a lower strike price in order to collect more profit and reduce the cost basis of the long call further.
The Risk and Benefits of Trading Poor Man’s Covered Call
Benefits
- Allows you to replicate a covered call with significantly less capital
- Carries a fixed level of risk for the life of the trade
- You can make adjustments if the trade goes against you in order to reduce your cost basis
- The short call strike helps you to make back some of the theta decay
Risks
- Profitability is limited if the trade goes above your short call strike price
- If implied volatility stays low, the intrinsic value will erode your profit potential
- The trade should be avoided around earnings releases due to sharp movements in the stock price in either direction
- Poor man’s covered calls carry assignment risk on both ends of the trade
Conclusion
The poor man’s covered call is a great replacement for a traditional covered call and can be very profitable if managed correctly. As you can see, it requires much less capital and can be a great way to mimic a traditional covered call.
Related Reading
Rolling a Covered Call Option – [When, Why and How]
Covered Call Options Trading Strategy Explained
Rolling a Poor Man’s Covered Call
