Poor Man's Covered Call - What is it?

A poor man’s covered call (PMCC) is a long call diagonal debit spread that is used to replicate a covered call position.

A traditional covered call uses long stock to “cover” the risk in the short call, while a PMCC uses a long-term call option instead. The PMCC is therefore a more capital-efficient way to simulate the covered call strategy without actually owning the stock.

The PMCC is often utilized by investors that wish to deploy a neutral to bullish outlook. A PMCC might therefore be used to express a bullish outlook on a stock or ETF, or in a case where the investor or trader is seeking to generate additional income from a neutral outlook.

DIRECTIONAL ASSUMPTION

Bullish

IDEAL IMPLIED VOLATILITY ENVIRONMENT

Low

PROFIT/LOSS CHART

A poor man’s covered call mimics the dynamics of the covered call strategy but at a fraction of the capital requirement. 

When you own a long-term in-the-money (ITM) call, the directional exposure is similar to owning 100 shares of stock. With that said, the call is still cheaper to buy than 100 shares outright. When you own a long call, you can sell a call against it to reduce the cost basis of the option while capping the upside profit potential of the long call itself.

Structure of a Poor Man's Covered Call (PMCC)

• Buy an Out-Month ITM Call Option: Instead of owning the stock, you buy a back-month call option (this may be a deep in-the-money LEAP).

• Sell a Near-Term OTM Call Option: You sell a shorter-term out-of-the-money call option on the same stock. 

In the above structure, the long-term call option acts as a substitute for owning the actual stock. 

The “poor man’s covered call” gets its name because it requires less capital than buying the stock outright. 

If the stock price rises above the strike price of the short-term call you sold, you benefit from the difference in premiums and the price appreciation of the long-term call. Most traders just trade the difference between the entry and exit price for this strategy, rather than intending to obtain shares with the long call, but that is certainly possible as well.

Ideally, the short call option will expire worthless, allowing the investor or trader to collect and retain the option’s premium, while the underlying stock's price gradually rises, boosting the value of the long back-month call option.

A poor man’s covered call mimics the dynamics of the covered call strategy but at a fraction of the capital requirement. 

A traditional covered call uses long stock to cover the risk in the short call, while a PMCC uses a back-month long call option as its coverage. The PMCC is a more capital-efficient way to simulate the covered call strategy without actually owning the stock.

Structure of a Traditional Covered Call

• Long Stock: You own 100 shares of the underlying stock.

• Short Near-Term OTM Call: You sell (or "write") a call option on that same stock.

With a traditional covered call, the investor or trader uses the long stock position as "coverage" or "collateral" for the sold call option. If the stock price rises above the strike price of the call you sold, you're obligated to sell your 100 shares at that strike price. If it stays below, you keep your shares and the premium you received from selling the call.

Structure of a Poor Man's Covered Call (PMCC)

• Long Back-Month ITM Call Option: Instead of owning the stock, you buy a long-term call option (often a deep in-the-money LEAP).

• Short Near-Term OTM Call Option : You sell a shorter-term call option on the same stock. 

In the above PMCC structure, the out-month call option acts as a substitute for owning the actual stock. It's "poor man's" because it requires less capital than buying the stock outright. 

Ideally, the short call option will expire worthless, allowing the investor or trader to collect and retain the short call option premium, while the underlying stock's price gradually rises, boosting the value of the long, out-month call option. 

WHEN TO CLOSE

In the best case scenario, a PMCC will be closed for a winner if the stock price increases significantly in one expiration cycle. This is because the call options will trade close to intrinsic value and the profit potential for the trade will diminish.

WHEN TO MANAGE

For losing trades due to the stock price decreasing, the short call can be rolled to a lower strike to collect more credit.

Deploying a poor man's covered call (PMCC) involves purchasing a deep in-the-money (ITM), back-month call option, while selling a shorter-term out-of-the-money (OTM) call option on the same stock. 

How to Deploy a PMCC

• Identify the Underlying: Choose a stock or ETF that you have a moderately bullish or neutral outlook on for the long term.

• Buy a back-Month Call Option: Purchase a deep in-the-money (ITM) call option with an expiration that's several months to years out. Ensure it has a high delta, so that the price of the call will move closely with the underlying stock price.

• Sell a Shorter-Term Call Option: Select a call option on the same stock with a shorter expiration, typically 30 to 60 days out. This option should be out-of-the-money (OTM), meaning its strike price is higher than the current stock price.

• Manage the Position: Monitor the position. As expiration nears for the short-term call, decide whether to let it expire, buy it back, or roll it to a later date or a different strike. Be aware of the risk of early assignment. If the stock moves significantly above the strike of the short-term call, there's a chance of assignment.

It’s important to keep in mind that while the PMCC uses less capital than a traditional covered call, it still requires active management, especially if the underlying stock price approaches or exceeds the strike of the short call.

A poor man’s covered call is a fantastic alternative to trading a covered call. In smaller accounts, this position can be used to replicate a covered call position with much less capital and much less risk than an actual covered call.

The setup of a poor man’s covered call is very important. If we have a bad setup, we can actually set ourselves up to lose money if the trade moves in our direction too fast. To ensure we have a good setup, we check the extrinsic value of our longer dated ITM option. Once we figure that value, we ensure that the near term option we sell is equal to or greater than that amount. The deeper ITM our long option is, the easier this setup is to obtain. We also ensure that the total debit paid is not more than 75% of the width of the strikes.

We never route poor man’s covered calls in volatility instruments. Each expiration acts as its own underlying, so our max loss is not defined.

Estimating the maximum potential profit for a Poor Man's Covered Call (PMCC) is fairly straightforward

The maximum profit of a PMCC is realized if the underlying stock closes right at the strike price of the short call option at its expiration. The profit will therefore be a combination of:

• The premium received from selling the short call.

• The appreciation in the value of the LEAP option (long-term call) from the time you established the PMCC up to the strike price of the short call.

Max Profit Example 

Suppose you have a bullish outlook on stock XYZ, currently trading at $100: 

• You buy a back-month call option with a strike of $90 for a cost of $15.00 (remember, this is per share, so the actual cost is $1,500 for the contract). This is deep in-the-money.

• You then sell a 30-day call option with a strike of $105 for a premium of $2.00 (or $200 for the contract).

To calculate the maximum potential profit:

Maximum Profit = (105 − 90 − 15 + 2) × 100

Maximum Profit = $200

In this scenario, your maximum potential profit is $200, which you'd achieve if XYZ closes right at $105 at the expiration of the short call.

This example assumes that the back-month option's price moves one-to-one with the stock's price (i.e., a delta of 1), which may not always be the case, especially for options that aren't deeply in-the-money. 

The maximum loss potential in a poor man's covered call is predominantly associated with the long back-month call option that is purchased. In the worst-case scenario, the value of this call option drops to zero. 

This is similar to a traditional covered call, where the maximum loss potential is associated with the long stock position. In the worst case-scenario, the value of the underlying stock drops to zero.

Max Loss Example

Suppose you're looking at stock XYZ, currently trading at $100.

• You buy a back-month call option with a strike of $90, paying a premium of $15.00 per share (or $1,500 for the contract).

• You then sell a 30-day call option with a strike of $105, receiving a premium of $2.00 per share (or $200 for the contract).

To calculate the maximum potential loss:

Maximum Loss = ($15.00 − $2.00) × 100

In this scenario, the maximum potential loss is $1,300.

The exact maximum profit potential & breakeven cannot be calculated due to the differing expiration cycles used. However, the profit potential & breakeven area can be estimated with the following formulas.

When a Poor Man's Covered Call (PMCC) gets assigned, it specifically refers to the short call option being exercised by its holder. 

When you have a short call that moves in-the-money (ITM), early assignment is possible where the counterparty exercises their right to execute the contract and convert it to 100 long shares for them, and 100 short shares for you. Since you don't actually own the stock in a PMCC, the assignment process is slightly different than with a traditional covered call:

• Exercise the Back-Month Call Option: If your long call option is deep in-the-money, you can exercise it to convert to 100 shares of stock, which would offset your 100 short stock position

• Buy 100 Shares and Sell the Long Call: You can buy 100 shares of the stock in the open market at the current price to offset your 100 short shares. You can then sell out of the remaining long call to close the position

Yes, there’s a chance that the poor man’s covered call can lose money.

A poor man’s covered call strategy involves owning the underlying stock and selling a call option on that stock. While this strategy can generate additional income from the option premium, there are several ways you can still experience losses:

• Decline in Stock Value: The most significant risk with a poor man’s covered call strategy is if the underlying stock declines in value. Even though you receive a premium from selling the call, that premium might not be enough to offset a significant drop in the stock's underlying price and the long call that you own.

• Opportunity Loss: If the stock price rises significantly above the strike price of the call option you sold, you'll miss out on any potential gains above that strike price because you're obligated to sell the stock at the strike price if the option buyer chooses to exercise the option.

• Early Assignment: There's always a possibility of early assignment (before expiration) with American-style options. If the option is in-the-money and there are dividends expected or other factors at play, the call option might be exercised earlier than you anticipate, leading to early exercise of the short call and a shift in the position itself.