QUESTION: What exactly is a poor man’s covered call?
ANSWER: A poor man’s covered call is similar to a traditional covered call strategy, with one exception. Rather than buying 100 or more shares of stock, you simply buy an in-the-money LEAPS call and sell a near-term out-of-the-money call against it.
Other than reducing the capital required, the reason you purchase LEAPS is to minimize the extrinsic value and theta decay.
Basically, a poor man’s covered call is viewed as a diagonal trade with a significantly longer duration.
First of all, you always start – just like when you’d use a traditional covered call strategy – by choosing a stock or ETF that you are comfortable owning for the long term. This is the crucial first step.
Take for instance Coca-Cola (KO).
The stock exemplifies the typical scenario that you should look for when using a poor man’s covered call.
The next step is to choose an appropriate LEAPS contract to replace buying 100 shares of KO.
If you were to buy KO shares at $45.87 per share, your capital requirement would be a minimum of $4,587 plus commissions ($45.87 times 100 shares).
If you look at KO’s option chain, you’ll quickly notice that the expiration cycle with the longest duration is the January 2019 cycle, which has roughly 525 days left until expiration.
You may prefer to buy a LEAPS contract that has a delta of around .80. As a result, let’s use the $40 strike for our example.
You can buy one options contract, which is equivalent to 100 shares of KO, for roughly $6.40, if not cheaper. Remember, always use a limit order – never buy at the ask price, which in this case is $6.65.
If you buy the $40 strike for $6.40 you’re out $640, rather than the $4,587 you would spend for 100 shares of KO. That’s a savings on capital required of 86%. Now you have the ability to use the capital saved ($3,947) to invest in other ways.
The next step is to sell an out-of-the-money call against your LEAPS contract.
It seems as though the only call strike worth selling in KO is the September 46 strike with 35 days left until expiration. If you chose a stock with a slightly higher price you could go out two, three, four or more strikes away from the current price of the stock. But let’s use a very conservative example so you can fully understand the basic risk/reward.
So, let’s say you decide to sell the 46 strike for $0.53, or $53, against your LEAPS contract.
Your total outlay or risk now stands at $587 ($640 for cost of LEAPS contract minus $53 in call premium).
At first, the premium seems small. But on a percentage basis selling the 46 strike call premium for $53 reaps a return on capital of 8.3% over 35 days. Of course, your upside is limited to the $46 call strike with this trade. But hey, is it so bad to lose out on some potential upside to make an 8.3% gain every 35 days?
An alternative way, if you wish to participate on a continued upside move in KO, is to buy two leaps in the stock and only sell one call against it. This will increase your deltas and allow half of your position to participate in a move past $46.
No matter the approach, you can continue to sell calls against your LEAPS contract every month or so to lower the total capital outlay. But remember, options have a limited life, so when you get closer to the LEAPS contract’s expiration you will simply sell the contract and use the proceeds to continue your poor man’s covered call strategy.
— Andy Crowder
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Source: Wyatt Investment Research