Poor Man's Covered Call: The Ultimate Guide

"Covered call" is an options strategy that generates a steady income every month, which might be familiar to some of you. But, in contrast, have you heard of an alternative strategy known as the "Poor Man's Covered Call," designed for those who are "poor" or do not want to commit large amounts of capital?

If executed appropriately, the poor man's covered call strategy is an options strategy that offers relatively lower risk and has the potential to generate a steady stream of passive income.

Before detailing a poor man's covered call strategy, I will briefly discuss the basics of a "covered call" option strategy.

What is poor man's covered call?

Do you know what a poor man's covered call is? An alternative to a covered call is a poor man's covered call (PMCC) or a synthetic covered call (SC). Compared to a standard covered call, this strategy involves less risk and capital investment.

It is crucial to pick a low-beta stock below one to execute this call. This is because the share value of these assets is less susceptible to price swings in the share market because of their low volatility.

Small investors can build a diversified portfolio by purchasing partial options from different digital assets.

PMMC used a call option strategy called Deep In the Money (ITM). Call options with a Deep ITM strike price are less than the underlying stock's current value. 

Using a long-dated LEAP with less capital and lower risk, you can replicate a covered call. LEAPS are long-term equity anticipation securities (LTEAS) that expire more than one year from the time they are purchased.

Diagonal debit spreads, or poor man's covered calls, lower upfront costs by using long call options instead of long stock positions to deliver the stock if needed. A lower upfront cost makes it easier for smaller accounts to generate income and leverage returns while reducing risks.

What is a covered call strategy?

Under the covered call strategy, the investor who sells call options owns an equal amount of the underlying asset. 

Investors who hold long positions in an asset then sell call options on that same asset as a way to generate income from it. In addition, a long position in the asset is a cover since it protects the seller if the buyer chooses to work out the call option.

Covered calls are common options strategies used to generate income as premiums from options. An investor who exercises a covered call expects a slight increase or decrease in the underlying stock price for the option's duration.

Investors holding long positions in an asset sell call options on that asset to execute a covered call. Covered calls are usually chosen by those who plan to have the underlying stock for an extended period but do not expect the price to increase significantly shortly.

Investors who believe the underlying price won't change much shortly will find this strategy ideal.

What is the poor man's covered call strategy?

Calls are bought and sold to execute the trade. Your underlying stock remains unchanged. Different expiration dates will be used to create a diagonal trade. A long call diagonal debit spread is technically called the poor man's covered call.

A Poor Man's Covered Call involves buying a long-dated LEAPS option rather than 100 shares of stock. A short-term call option that is out-of-the-money usually is sold after an in-the-money long-dated call option is purchased.

As a result of selling the short call, you will lower your cost basis on the LEAPS that you own. If you hold a PMCC position above the strike of your LEAPS option, you maximize your profit.

An example

TSLA is currently trading at $720

Purchase an ITM call option with a delta one for $30

For $8.25, sell OTM call options with a strike price of $750

A total of $2,175 will be due (30-8.25)*100

By entering into a poor man's covered call position, you take the position equivalent to a covered call, but you only need $2175. However, you will need $7,200 in capital to enter a covered call position.

Poor man's covered call vs. covered calls

Stock prices are expected to stay above current levels and move slightly higher. If you could trade a poor man's covered call, when would you do it? Of course! Instead of buying 100 Boeing shares for $18,000! What is the suitable time to trade a covered call?

A call option in the money at a later expiration would be purchased instead of a stock. The call option gains .95 cents for every dollar the stock moves. A Delta of 0.95 is ideal for a call option farther in the money.

When should you use a poor man's covered call?

Now, this should be a simple question. A poor man's covered call can be an excellent opportunity for traders with a small account or who do not want to take as much risk. You can create a synthetically equivalent position using this strategy even if you do not have $7,200 to buy the stock. Moreover, covered calls can be replicated with this approach.

Pro-tip to follow

If we go for a covered call as a poor man's strategy, we should be aiming to reduce the overall cost. A cheaper call option can be purchased, or a higher call option can be sold. 

Due to the economic equivalent of a covered call position, the optimal time to trade a poor man's covered call is when you expect the price to rise above the call option's strike price.

Generally, to do this, you move the delta a little lower. For example, if you sell a 0.95 delta call option, you might be able to get a lower price. You can also sell a "less deep" OTM call for a higher price if you are highly convinced that the stock will not rise to a certain level.

How to calculate a poor man's covered call?

You can implement this strategy by buying an ITM call in a longer-term expiration cycle and selling a near-term OTM call.

Following these steps is recommended when calculating a long call diagonal debit spread.

1. To find the stock's price, enter the symbol.

2. Following that, you can either buy or write a deep ITM call.

3. There will then be an option for you to choose from. For example, you can compute the cost per contract by selecting one.

4. As well as buying and writing short calls, you can also do both. LEAPS are used to sell short calls.

5. A strike price and expiration date should be considered.

6. Spread price illustrates the net debit or credit amount of an option spread.

Tips for trading poor man's covered calls

Choosing the suitable options and managing the trades appropriately over time are the keys to success with a poor man's covered call.

Among the quintessential tips to remember are:

• Make sure the stock has low implied volatility (low beta, for example). Do not invest in companies that report earnings soon or have other upcoming events that could increase volatility.

• You should select long in-the-money call options with extrinsic values equal to or lower than short options. Opportunities will be easier to find the deeper you go into the money. Call options are more expensive if they are deep in the money.

• Ensure that the total debit paid isn't more than three-quarters of the difference between the strike prices. That way, you're leaving adequate room for upside.

• The options are trading close to their intrinsic value, so you might want to close the trade if the stock price increases significantly. Alternatively, close the position if the stock price falls below the strike price, or roll the short call to a reduced strike price to offset losses.

Stock prices are expected to rise sharply in the future, in which case both strategies will profit from a portion of the total gains until the short call's strike price is reached. The profit is not as good as covered calls, but the return on investment may be more significant. Poor man's covered calls also have limited upside potential.

Poor man's covered call: risks and rewards

Poor man's covered call is a great way to save money, as it's less expensive than a typical covered call. Compared to traditionally covered calls, you can save up to 80% on out-of-pocket costs.

That kind of reduction gives you more opportunities to invest when you don't have much money to spend. You can fund your investments with your profits.

Despite slow eroding in value over time, LEAPS call option premiums to deteriorate in worth over time as a poor man's covered call.

It means you will not make as much profit from it as you would from a traditional covered call. You should expect a maximum profit of at least 10% less than you would get from a standard covered call.

The idea of earning lesser money does not appeal to anyone. Despite this, most investors prefer to spend less money and lower risks.

Poor man's covered calls are not as lucrative as those of rich man's, but the risk-return ratio is more significant. For every $100 at risk, you might aim to make $1 per month on covered calls, or 1% per month. Poor man's covered call might provide a return on risk of $1 on each $14 risked, providing a return of 7%+ over the same period.

Focus on your investment's long-term effects. While you may not be able to profit quite as much, you could earn enough to make it possible for you to place large bets with a higher return on your investment.

Are you a candidate for a poor man's covered call?

Anyone could benefit from a poor man's covered call. It is more common for these people to use the strategy:

• Concerned about losing money by new traders

• Traders looking to reduce the risk of other investments

• Traders interested in exploring market and stock price fluctuations without investing a lot of money

• You might be a worthy candidate for a poor man's covered call if you belong to any of these categories. Anyone can use it. Having a lower risk also means you have a lower maximum profit, though.

How to execute a poor man's covered call?

You plan to place a poor man's covered call. Here are the steps you need to take.

1. Choose a low-delta stock that you would like to own in the long term

2. In place of a traditional covered call, buy a LEAPS option instead of 100 shares of the stock
   

3. When your investment price increases, you may want to roll it over with additional capital, so you adjust your investment when necessary

4. Allow your calls to expire worthlessly and collect your earnings.

5. A stock's value can always decline before it expires. If this occurs, you might consider reducing your investment capital.

6. You may or may not do that, though, depending on how you anticipate the stock will move. You should perhaps wait for the value to rebound if it's a short-term drop in value.

An investment strategy's underlying mechanisms are best understood by experimenting with it. You can learn a lot without putting much money at risk without requiring much capital. Take a look at your trading platform to see if you can use the poor man's covered call.

A covered call strategy with limited risk & losses

You can't believe this is true, can you? What a great idea! But there are some downsides involved. You can only make so much money.

You will only benefit a portion of the gains if there is a large movement in the stock. The stockholder would earn $4,000 in this example if the underlying strike price increased by $40. It would make $2450 for the covered call and $2320 for the poor man's covered call.

This strategy is prevalent among traders because it involves minimal capital and carries a low risk associated with a potential downward movement.

Alternative strategies to consider 

Income can be generated from any option strategy that generates a net credit. As a result, investors may want to consider strategies other than the poor man's covered call alternative.

The following strategies are similar:

1. With a cash-secured put, you sell the option while putting money aside to buy the stock if the option is assigned. The premium payments are kept as income if the option isn't set.

2. A credit spread is a transaction in which one option is bought and sold at a net credit. A vertical spread has an unlike strike price, a calendar spread has a different expiration date, and a diagonal spread has a different strike price and expiration date.

3. Classic covered calls are also an option you may consider. With the Snider Investment Method, you can create a portfolio that ensures a steady stream of income and cash flow during retirement by combining stocks, options, and cash, using a specific technique applied in an orderly manner to maximize your portfolio's income potential.

FAQs

1. A poor man's covered call is a good strategy.

An alternative to trading covered calls is a Poor Man's Covered Call. By using this position, smaller accounts can mimic covered call positions with much less capital and less risk than covered calls. This is where the setup is critical.

2. A poor man's covered call: How do you trade it?

Poor man's covered calls are bought by short-term out-of-the-money calls sold by a long-term, deep-in-the-money call. As a result, the long-term accepted call can be a fraction of the cost compared to the long stock position.

3. What could go wrong with covered calls?

A covered call strategy has a maximum loss of the purchase price minus the premium received on the option. Covered call strategies can only profit up to the strike price of the short call option. The price of the underlying stock is less than the premium received.

4. Are poor people at risk of covered calls?

Low-risk and low-cost covered calls are a way to sell calls. Long call diagonal debit spreads are technically poor man's covered calls. The trade involves buying and selling a call. The underlying stock must remain unchanged.

5. What are the risks of poor man's covered calls?

While you risk less capital, you are almost as exposed as if you owned 100 shares. Therefore, investors should consider that options are risky and can lose 100% of their money.

Bottom line

The popular way to earn income from options is through covered call options. It's a relatively low-risk strategy, but it can be expensive to implement depending on the underlying stock price.

Those who use covered calls to generate income may not mind, but long-term investors may want to consider alternatives.

Poor man's covered call reduces upfront costs by using a long call option instead of a long stock position to deliver the stock if necessary. Smaller accounts can generate income more easily while leveraging returns and reducing risks at a lower upfront cost.