What is a poor man’s covered call?

Posted on: June 28th, 2022
By: Tadeo Lemus

  • They’re a good tool to keep consistent cash flow
  • They’re not hard to understand or super risky

It’s possible to generate comparable cash flow as with a regular covered call when done correctly.

Let’s describe the poor man’s covered call

A poor man’s covered call (aka PMCC) is when you buy an in-the-money call with a far-out expiration date and sell an out-of-the-money call with a closer expiration date. It’s basically a spread, which is good for collecting premiums and defining risk but also more risky and complicated.

It’s not very intuitive but definitely worth looking into it to expand your knowledge of options.

Why does the poor man’s covered call work?

Consider stock options as having an infinite expiration date, with a delta of 1.00, and think about them as if they were options with a delta of 1.00. In other words, for every $1 change in the underlying, their price would move by $1.

Consider them as a form of collateralized borrowing using infinite -DTE, 1.00-delta “options” (i.e., shares) as the collateral. Those characteristics make the “options” more pricey. However, if we convert those stocks into actual options – that is, with an expiration date and a lower delta – our security is considerably cheaper!

This increases the danger, as we’ll see, but consider how the PMCC might appeal in the first place.

What impact does PMCC have on cash flow?

A PMCC is more capital-efficient if done correctly. It may deliver comparable cash flow from far less collateral. However, there’s a chance the underlying call will expire worthless when shares would have kept their value had it not been for the premium (“going to zero”).

Let’s say you write a covered call on XYZ trading at $150. You sell a $160 with a 0.40-delta expiring on 2023-01-07 for a premium of $2.50 ($250 credit).

A traditional covered call would require $15,000 of collateral ($150 * 100). If the short call expires worthless, the returns will be $250 / $15,000 = 1.6% on collateral.

A PMCC against a 9-month 0.90-delta call ($100 exp. 2023-06-10) sells for $50 which requires a capital of $5000. If the short call expires worthless, your returns are $250 / $5000 = 5% on collateral.

That’s basically how a poor man’s covered call works (PMCC). Buy a deep-in-the-money, longer-dated call option instead of buying the full 100 shares.

Without actually owning any shares, it’s not a true covered call. It’s more of a diagonal debit spread. This brings up some issues:

You need specific permissions from your broker to enable this feature. For covered calls, level 1 (essentially the standard) is enough, but level 3 is required for similar spreads like the poor man’s covered call.

It’s more difficult to set up and maintain. It requires a second contract with an expiration date that makes sense in relation to the short call. This long call may also need to be handled separately from the short call.

On the expiration date of a short call, it’s impossible to predict the share price’s P&L with absolute accuracy. And the more volatile the share prices are over time, the less accurate your guess will be.

This brings up some unlikely but doable assignment problems like getting an in-the-money short call assigned during after-hours. Most brokerages may try to sell your long call to close the position but this isn’t always the case.

For a PMCC, it’s safer to close/roll your short contract instead of waiting for it to expire as with a regular covered call.

How to choose stocks for a poor man’s covered call?

Stock-picking criteria are approximately the same as for a standard covered call. I’d be even more conservative, sticking with exceptionally steady underlying.

Because shares can recover their value during a price downturn, they are frequently referred to as “hedge against the market.” They have the ability to rebound in virtually any situation, whether it be next week or years later. Long call options may return value, although it must first happen before expiration and generally take place above its former price to offset time decay.

Let’s assume that the underlying falls 20% and remains there for all eternity. Your shares still retain 80% of their value, yielding whatever dividends the firm pays out. It’s not ideal, but it certainly isn’t a lost cause.

With a PMCC, your call would go to zero or near zero. It all depends on the strike price you chose.

As a result, if you truly want to use this approach, the first step is to reduce the probability of going to zero. That implies that uninteresting “boomer” businesses are in and anything promoted on Twitter is out.

What you should know about the PMCC

I can’t go into all of the nuances and justifications of the PMCC in a single post. But, to put it as succinctly as possible:

It’s more difficult to set up because you’re dealing with two option contracts instead of one. Your broker will also have different permissions and margin rules to enforce.

When everything goes smoothly, a covered call with an early expiration date is more profitable than a normal covered call (thanks to significantly lower capital requirements).

When all else fails, it’s more challenging to rebound. The share price must return far more than the losses incurred in a short period of time…and without receiving dividends while you wait.

Covered calls are most effective for stocks you want to keep for a long time. However, with the PMCC, avoiding volatile companies is even more crucial. (That might imply taking lower short call premiums as well.)

If you want to take advantage of covered calls but lack the capital to acquire 100 shares of a high-quality asset, the PMCC may be a viable option.

That isn’t to say, though, that it is wise.

When assets are limited, even small losses can be devastating. As a result, ironically, some traders who are the most eager to employ the PMCC are least able to handle its risk.

In that case, I’d concentrate on making active money to invest in excellent firms and, once I’m ready, write regular covered calls (if appropriate).

The PMCC could be used as a more aggressive approach in one portion of a larger portfolio. It also places important options concepts in perspective. But many individuals and most of the time, simpler methods are preferable.

Have any questions or comments? Write them below!

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