Selling covered calls is a great way to mitigate the risk of selling calls. But, they can also be very expensive because you need at least 100 shares of a stock to do it. One way to offset the cost is a strategy called a poor man’s covered call. A poor man’s covered call is done by buying an in-the-money call and selling an out-of-the-money call with a nearer expiration date.
If you are having trouble understanding some of the terms used in this article, check out our glossary of option trading terms. Keep reading to learn when to use the poor man’s covered call, how this kind of option strategy works, and the pros and cons of relying on it.
A Poor Man’s Covered Call Strategy
When to use the poor man’s covered call
A poor man’s covered call is best used when a trader can’t afford the 100 shares of a stock needed to cover a call. This is most likely to be the case with expensive stocks, like Boeing or Alphabet Inc (Google). It is also a good strategy when the trader is new to options trading and doesn’t want to invest too much yet. The trader will also want a stock that is bullish (going up) in the long term and has low implied volatility.
Implied volatility is the likely change in a given security’s price that is calculated using a pricing model. This is oppose to historical volatility that is calculated using historical data. Implied volatility is used because it is more accurate in most situations.
How it works
A poor man’s covered call is a replacement strategy for covered calls that requires the buying of an in-the-money LEAPS call with a months long expiration date and selling an out-of-the-money with a weeks long expiration date. A LEAPS call stands for Long-Term Equity Anticipation Security, and means A long term call option. The in-the-money calls will act as hedge if the stock price goes down. This will prevent the traders from losing as much as they would if they were trading naked calls.
The Delta of the option that the trader purchases should be approaching, but less than, one. This means that the the price of the option would increase or decrease slightly slower than the stock. The effects of this inelasticity will be explored later on in the article.
Buying calls for the poor man’s covered call allows the call to be hedged. This strategy is different than a covered call, which uses 100 shares of the stock as a hedge. This leads to a call that is protected but not fully covered. What’s suppose to happen is if the calls the traders are selling gets called then the calls they’re buying can be called to cover it.
Strengths and weaknesses
Poor man’s covered calls are a replacement strategy for covered calls that have many of the same strengths and weaknesses. One of those strengths is that it allows the traders to hedge their bets while still making a decent profit. The difference is that instead of being hedged by the stock, the trade is hedged by the calls that the traders purchased.
Since it shares the same strengths as a covered calls, it makes sense poor man’s covered calls would share the same weaknesses as well. One of these weaknesses is that it can be hard to find the right stock to use it. I already stated above what kind of stock would be best but those kinds of stock are few and far between.
Another weakness of the poor man’s covered call is that it will likely not gain as much profit as a normal covered call. This is because, unless the volatility for a stock is zero, the price for the call will not change at the same rate the stock would. For this reason you would also loose more money if the stock price goes down than with a covered call.
A poor man’s covered call is a substitute for a covered call that involves buying in-the-money calls and selling out-of-the-money calls with lesser expiration dates. This tactic is best used on stocks you expect to go up in the long term and have little volatility. Like covered calls, the strategy allows traders to make a decent profit while hedging your bets. It can also be hard to find the right stock to use the strategy on. A poor man’s covered call also is a less effective hedge and makes less profit.
I hope this has helped you understand poor man’s covered calls. Have a good day, and happy trading!