The Poor Man’s Covered Call is an options trading strategy that offers a way to generate
income similar to a traditional covered call but with significantly less capital outlay.
This strategy is particularly attractive to traders with smaller accounts. This article
explains how to use the Poor Man’s Covered Call and its key benefits and risks.
Understanding the Poor Man’s Covered Call
A Poor Man’s Covered Call involves:
- Buying a Deep In-the-Money (ITM) Call Option: This acts as a substitute for owning the underlying stock.
- Selling a Short-Term Out-of-the-Money (OTM) Call Option: This is the same as in a traditional covered call.
Essentially, you’re using a long call option to control shares of stock instead of buying
them outright.
How the Poor Man’s Covered Call Works
1. Select a Stock
Choose a stock you expect to remain stable or slightly increase in price.
2. Buy a Deep ITM Call Option
Buy a call option that is deeply in-the-money (ITM).
- Deep ITM: The strike price is significantly below the current stock price.
- Long Expiration: Choose an expiration date several months in the future.
- High Delta: Look for a delta close to 1.00 (e.g., 0.80 or higher). This means the option price will move almost dollar-for-dollar with the stock price.
3. Sell a Short-Term OTM Call Option
Sell a call option with a strike price above the current stock price.
- OTM: The strike price is above the current stock price.
- Short Expiration: Choose an expiration date closer to the present (e.g., weekly or monthly).
4. Manage the Trade
Monitor the stock price and option values.
- If the stock price rises: Both call options will increase in value.
- If the stock price stays stable: The short-term OTM call will lose value due to time decay, generating profit.
- If the stock price declines: Both call options will decrease in value, but the long ITM call will retain more value.
Example
Stock XYZ is trading at $100.
- Buy a LEAPS call option with a $70 strike price, expiring in 1 year.
- Sell a call option with a $105 strike price, expiring in 30 days.
Benefits of the Poor Man’s Covered Call
- Reduced Capital Outlay: Buying a LEAPS call is cheaper than buying 100 shares of the stock.
- Similar Profit Potential: You can still profit from the stock’s upward movement.
- Income Generation: You earn premiums from selling the short-term call options.
Risks
- Limited Upside: Your profit is limited if the stock price rises significantly.
- Downside Risk: You can still lose money if the stock price declines.
- Time Decay: The long call option loses value over time.
- Volatility Risk: Changes in volatility can impact option prices.
Important Considerations
- Stock Selection: Choose fundamentally sound companies with moderate volatility.
- Strike Price Selection: Carefully select strike prices to balance income potential and risk.
- Expiration Dates: Choose appropriate expiration dates to manage time decay.
- Risk Management: Understand your maximum profit and loss potential.
Conclusion
The Poor Man’s Covered Call can be a capital-efficient way to generate income and participate
in stock price appreciation. However, it’s essential to understand the risks and manage your
trades carefully. This strategy is best suited for experienced options traders.
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Frequently Asked Questions (FAQ)
1. What is a Poor Man’s Covered Call?
A Poor Man’s Covered Call is an options strategy that involves buying a deep
in-the-money (ITM) call option and selling a short-term out-of-the-money (OTM) call
option on the same stock.
2. How is it different from a traditional covered call?
In a traditional covered call, you own the underlying stock. In a Poor Man’s
Covered Call, you use a long call option to control the stock.
3. What is a deep in-the-money (ITM) call option?
A deep ITM call option has a strike price significantly below the current stock
price.
4. What is a high delta?
A high delta (close to 1.00) means the option price moves almost dollar-for-dollar
with the stock price.
5. What is an out-of-the-money (OTM) call option?
An OTM call option has a strike price above the current stock price.
6. What are the benefits of using a Poor Man’s Covered Call?
Benefits include reduced capital outlay, similar profit potential to a covered
call, and income generation.
7. What are the risks of using a Poor Man’s Covered Call?
Risks include limited upside, downside risk if the stock price declines, and time
decay affecting the long call option.
8. What type of stocks are suitable for this strategy?
Fundamentally sound companies with moderate volatility are generally suitable.
9. Is the Poor Man’s Covered Call less risky than buying the stock outright?
It can be less risky in terms of capital outlay, but it still carries risk, and
potential losses are different from owning the stock.
10. Is this strategy recommended for beginner traders?
This strategy is generally recommended for experienced options traders who
understand the nuances and risks involved.
