What Is a Poor Man’s Covered Call?
Originally posted on https://investormint.com/financial-terms/p/what-is-a-poor-mans-covered-call
A poor man’s covered call is a trading strategy that limits risk and, as the name implies, doesn’t require a large financial commitment.
The strategy works similar to the typical covered call strategy. The poor man’s covered call, however, doesn’t force you to buy stock. Instead, you buy in-the-money long-term equity anticipation securities (LEAPS) call. When the time comes, you sell a near-term out-of-the-money call against these LEAPS call options.
If you don’t have experience with LEAPS, then you can think of them as options contracts with expiration dates longer than a year. By choosing LEAPS, you get long-term exposure that reduces the risk of your investment.
Need to revisit the basics before learning more, check out this Options Trading for Dummies guide.
The Poor Man’s Covered Strategy
The poor man’s covered call strategy is an alternative to a traditional covered call. Most people use a poor man’s covered call strategy because it requires less buying power.
In other words, you don’t need a lot of money to invest in the strategy. Even though you don’t need deep pockets, you can still generate significant profits.
Experts break the poor man’s covered call into two main steps. These steps include:
- Buying a call option in a long-term expiration cycle
- Selling a call option in a near-term expiration cycle
Example Poor Man’s Covered Strategy
Let’s use an example to gain a better understanding of the poor man’s covered strategy and how you can execute it successfully.
To start, you should choose a low-beta stock. A stock with low volatility typically makes the poor man’s covered strategy more effective because you don’t get as many price swings in the share price.
A rule of thumb is to look for stocks with betas less than 1. You want to choose an option with less volatility than the overall market.
Once you find a stock, purchase one options contract using a limit order so you don’t pay the full ask price. Any good options broker, like tastyworks, will make it simple to specify a limit price.
Now, choose a strike to sell against your LEAPS contract.
Each month, you can sell calls against your LEAPS contract to reduce the amount of risk you hold in the trade overall. As you get closer to the LEAPS contract’s expiration, it is usually best to sell the contract, otherwise time-decay (or theta) erodes the premium of the option at a faster pace.
You can use the money you receive from selling shorter term call options to invest in another poor man’s covered call or try a different strategy.
Risk and Rewards of Poor Man’s Covered Call
The great thing about a poor man’s covered call is that you spend less money than you would on a typical covered call. You can often save as much as 80% or more on out-of-pocket costs versus a traditional covered call.
When you don’t have a large amount of money to spend that kind of percentage reduction gives you more opportunities to invest. Ideally, you will use your profits to fund more investments.
The downside to a poor man’s covered call is that the LEAPS call option premium erodes in value over time, albeit at a slower pace than the short call premium.
That means you will never make as much money from it as you would from a standard covered call. Expect a max profit that is around 10% or more lower than the max profit that you could get from a standard covered call.
No one likes the idea of making less money than possible. On the other hand, most investors do like the idea of spending less money and lowering risk.
You won’t make as much money from a poor man’s covered call but your return on risk could be significantly larger. In a covered call you might aim to make $1 per month for each $100 at risk, or 1% per month. With a poor man’s covered call, the return on risk might be $1 on each $14 risked, leading a 7%+ return in the same time frame.
It’s important to focus on the long-term effects of your investment. You might not profit to quite the same extent, but you could earn money that eventually makes it possible for you to place larger bets with larger returns.
To view the risk and reward of the poor man’s covered call, thinkorswim has a trading platform that features risk graphs at no extra cost. It’s widely regarded as one of the very best options trading platforms, and is owned by TD Ameritrade.
Is a Poor Man’s Covered Call Right for You?
A poor man’s covered call could work for anyone. More often than not, though, the people who use the strategy include:
- New traders worried about losing money
- Traders that want to offset the risk of other investments
- Traders looking to explore market and stock price fluctuations without investing much money
If you fall into any of these categories, then a poor man’s covered call is probably right for you. Then again, anyone can use the strategy. You need to understand, though, that the lower risk means that you lower your max profit.
How to Place a Poor Man’s Covered Call
So, you’ve decided to place a poor man’s covered call. Follow these steps to initiate a successful strategy.
- Find a low-delta stock that you want to own long-term
- Instead of buying 100 shares of the stock as you would for a standard covered call, purchase a LEAPS option
- Adjust your investment when necessary, such as when a stock price increase and you want to roll your investment over with additional capital
- Collect your earnings by letting your calls expire worthless
There’s always the possibility that a stock could lose value before it expires. When this happens, you may want to consider reducing the capital that you have in the investment.
Whether you do that, however, depends on how you think the stock will move in the near future. If it’s a short-term drop, then you should probably leave the investment alone and wait for the value to rebound.
Trying an investment strategy is the best way to understand its underlying mechanisms. If you’re interested in the poor man’s covered call, go to your trading platform and give it a try. It requires relatively little capital and has a low risk, so you can learn a lot without jeopardizing much money.
To get started trading the poor man’s covered call, sign up at tastyworks and practice risk free. The broker also has a live streaming network featuring top options traders so you can learn throughout the trading day, or view a back catalog of educational videos designed to get you up to speed in a hurry.