Unlocking Income with the “Poor Man’s Covered Call
In the world of options trading, the “covered call” strategy reigns supreme as a reliable income-generating tool. However, for investors with limited capital, the upfront cost of buying 100 shares to implement a traditional covered call can be a barrier to entry. Enter the poor man’s covered call (PMCC), a clever strategy that cleverly utilize options contracts to simulate traditional call option portfolio structures while reducing the cost of entry.
What is a Poor Man’s Covered Call?
The PMCC, also known as a synthetic covered call or a long call diagonal spread, is essentially a replica of a traditional covered call achieved through a combination of two options contracts:
- Buying a long call option with a longer expiration date and a lower strike price (the “deep in-the-money call”). This acts as your underlying stock position, providing leverage and limiting your downside risk.
- Selling a short call option with a shorter expiration date and a higher strike price (the “out-of-the-money call”). This generates premium income, similar to selling a covered call on the underlying stock.
By combining these two options, you effectively create a synthetic long position on the stock with a limited profit potential capped by the strike price of the short call. This allows you to capture premium income while still participating in potential upside movement of the stock price, all with less upfront capital than a traditional covered call.
Benefits of the Poor Man’s Covered Call:
- Lower capital requirement: Compared to a traditional covered call, the PMCC requires less upfront capital because you don’t need to purchase the underlying stock. This makes it accessible to investors with smaller portfolios.
- Limited downside risk: The deep in-the-money call purchased in the PMCC acts as a buffer against significant losses if the stock price falls. Your maximum loss is limited to the premium paid for the long call.
- Income generation: By selling the short call option, you generate premium income regardless of the stock price movement. This can provide a steady stream of income for your portfolio.
- Flexibility: The PMCC can be adjusted based on your market outlook and risk tolerance. You can choose different strike prices and expiration dates for the options contracts to tailor the strategy to your specific needs.
Things to Consider Before Implementing a Poor Man’s Covered Call:
- Options complexity: The PMCC involves two options contracts, which can be more complex to understand and manage than a traditional covered call. It’s crucial to have a good understanding of options basics before attempting this strategy.
- Time decay: Both options contracts in the PMCC experience time decay, which can erode your profits over time. It’s important to monitor your position and adjust it as needed, especially as expiration approaches.
- Potential for assignment: If the stock price rises above the strike price of the short call before expiration, you may be assigned the stock. This can limit your upside potential and force you to buy the stock at a higher price than you might otherwise want.
Let’s walk through an example of the poor man’s covered call strategy:
Assume you are interested in a stock called ABC Inc., which is currently trading at $50 per share. Instead of buying the stock, you decide to implement a poor man’s covered call strategy using options.
- Step 1: Long-Term Call Option Purchase
You purchase a long-term call option on ABC Inc. with a strike price of $50 and an expiration date one year from now. The cost of the long-term call option is $5 per contract. Each contract typically represents 100 shares of the underlying stock. So, you buy one contract for a total cost of $500 (100 shares x $5).
- Step 2: Short-Term Call Option Sale
To generate income and offset the cost of the long-term call option, you sell short-term call options against your long position. Let’s say you sell one short-term call option with a strike price of $55 and an expiration date one month from now. The premium you receive for selling this call option is $1 per contract. Again, each contract represents 100 shares, so you receive $100 (100 shares x $1) in premium.
- Step 3: Income Generation and Cost Reduction
If the short-term call option you sold expires worthless (out of the money), you keep the $100 premium. This income helps reduce the net cost of your long-term call option position from $500 to $400 ($500 – $100).
- Step 4: Repeat Short-Term Call Option Sales
As the expiration date of the short-term call option approaches, you can repeat the process by selling another short-term call option against your long position. This generates additional income and further reduces the net cost of your long position.
- Step 5: Monitoring and Adjustments
Throughout the strategy, it’s important to monitor the movement of the underlying stock price, as well as the value of the options. If the stock price rises significantly and approaches or surpasses the strike price of the long-term call option, adjustments may be necessary to manage risk or capture potential profits. You may consider rolling the short-term call option to a higher strike price, extending the expiration date, or closing out the position entirely.
It’s essential to note that this example is simplified for illustrative purposes, and actual options trading involves various factors and complexities. It’s crucial to conduct thorough analysis, consider market conditions, and understand the potential risks before implementing any options strategy.
PMCC Buying Power Examples
1. What are some good candidates for a Poor Man’s Covered Call?
The PMCC is suitable for stocks that you believe will remain sideways or experience moderate upward movement. It’s not ideal for highly volatile stocks or stocks with a significant potential for downside movement.
2. How do I manage a Poor Man’s Covered Call position?
It’s important to monitor your PMCC position regularly and adjust it as needed. You may need to roll your options contracts to extend their expiration dates or adjust the strike prices to maintain your desired risk profile.
3. How do i use Poor Man’s Covered Call for Income Generation or Profit ?
The income generated from selling the short-term call options is a crucial aspect of the strategy. Consider strike prices and expiration dates that allow you to collect a meaningful premium while still maintaining a reasonable probability of the short-term call options expiring worthless (out of the money).
4. Can i adjust my Covered Call if the stock prices rises significantly ?
Strategy Adjustments: Anticipate potential adjustments to the strategy. If the stock price rises significantly, you may need to roll the short-term call options to higher strike prices or extend the expiration dates to avoid potential assignment or capture additional gains. Assess the feasibility and availability of such adjustments when choosing the initial strike prices and expiration dates.
The poor man’s covered call is a versatile options strategy that can be a valuable tool for income generation in your portfolio. By understanding its mechanics, advantages, and limitations, you can leverage the PMCC to capture premium while managing your risk exposure. Remember, thorough research and careful planning are crucial for success in any options strategy, so consult a financial advisor if needed before implementing the PMCC.
I hope this article has provided you with a comprehensive overview of the poor man’s covered call strategy. With careful planning and execution, this strategy can be a powerful tool for generating income and enhancing your overall investment returns.