A poor man’s covered call (also known as a leveraged covered call) is a strategy favored by options traders with small accounts. This is also where the name comes from. Some of you will have heard of the covered call strategy. If not, you should read about this strategy first to better understand the leveraged covered call.
Covered Calls – Summarized
Before we continue with the poor man’s covered call, quick reminder of the normal covered call strategy:
- You buy 100 shares
- Then you write a call and get an option premium
- If the stock price stays below the strike, you will keep the stock and the premium from the sold call
- If the stock price moves above the strike and the option expires above it, you will keep the premium, but you have to sell the stock at the strike price
- The disadvantage of the covered call strategy: Especially, if you have more expensive shares, the expenses for buying this share are usually relatively high. A simple example: if a stock costs $150, then we’re talking about $15,000 that you need to be able to sell one call option. And such amounts of money often are simply too high for most private options traders. If they were not, there would have been no reason for them to trade poor man’s covered calls.
Now let’s look at the man’s covered call strategy in the next section.
How Does Poor Man’s Covered Call Work?
- As opposed to a normal covered call, you don’t buy a stock
- Instead, you buy an in-the-money call with the longest possible expiration time
- After this, you sell an out-of-the-money call that has a shorter expiration than the call you bought
Let’s check an example:
In the screenshot, you can see the stock of Netflix. The in-the-money strike for the purchased call (long call) lies at $285, and the sold call (short call) has a strike of $400.
For one in-the-money call, you would have to pay $700. For the short call, you would get a premium of $550.
As you can see, as opposed to a normal covered call, you would save a lot of money. Let’s check how much it is: in case of a covered call, you would buy 100 shares of Netflix at a current price of around $328, which would cost you $32800. Therefore, using a poor man’s covered call strategy, you would save $32100.
What would be the ideal situation for this type of trade? Ideally, the stock price would reach the strike of the sold call on the last day when the sold call expires, but it would not touch the strike. In this case, you would get the premium of the expired sold call but also the maximum profit of the purchased call.
But of course, this is a very theoretical situation, and the probability that this scenario would happen is very low. Usually, you would achieve positive results somewhere in the middle as the profit of the purchased call also depends on the current implied volatility and the time decay.
Advantages Of A Poor Man’s Covered Call
- This strategy saves a lot of the money you need when you buy a stock (as in the case of a covered call). In our example, we have an expense of $700. For a normal covered call, you would have to spend $32800
- The risk of a poor man’s covered call is fixed thanks to the bought call. The maximum loss is the expense of the purchased call, minus the sold call. In our case, it would be $150 ($700 – $550)
Disadvantages Of A Poor Man’s Covered Call
- A leveraged covered call is a so-called directional trade. This means that your profit depends on the increase in the stock price. However, directional trades are always more difficult to trade successfully than neutral trades, where the probability of success is on your side.
- Implied volatility can also be a disadvantage. The question is, when should you trade a poor man’s covered call? If you do this strategy in a high-volatility environment, the call you buy will be expensive. And as soon as the implied volatility decreases, the purchased call can lose value even as the stock price increases.
- The next disadvantage is time decay. If you buy the stock to write a normal covered call on it, you have the advantage that the stock does not have a time decay. Sure, choosing a longer term for the long call is helpful. Nevertheless, with each passing day, the time value declines. And with that, you have another force working against you.
- If you own a stock and write a normal covered call, you will receive a dividend (in the case you have bought a dividend stock). But when you trade a poor man’s covered call, you will get no dividends.
Is This Strategy Worthwhile?
As we have seen, this strategy has advantages and disadvantages, and everyone must get his / her own opinion about it. As for me, I don’t use this strategy. I know how it works, and I’ve tried it a couple of times. But for me, the cons outweigh the pros. Actually, there are two main reasons why I don’t use this strategy.
Of course, you can trade a poor man’s covered call and save money as opposed to a normal covered call. But that saving appears in a different light when you do it through a margin account.
If you have a margin account, you don’t spend the whole amount in the case of a normal covered call, but only a part of it. It’s still more than buying a call for a poor man’s covered call. But it’s nevertheless less if you have a cash account. Therefore, the advantage over a normal covered call is not as big as someone would imagine.
The second reason I don’t recommend this strategy, especially for beginners, is that it has some complexity. You have to look at implied volatility with this strategy, you have to keep an eye on time decay. What if the price falls below the purchased call? How can you adjust it? In my opinion, the individual aspects that speaking in favor of trading a poor man’s covered call, make this strategy too cumbersome, especially for beginners.
These are the reasons I don’t trade poor man’s covered calls. Of course, this is not a piece of trading advice but just my personal opinion. If someone is successful with this strategy, you have my respect. And anyone who has never tried it, should give it a chance to gather practical experience. For beginners, I definitely recommend doing this with a paper trading account.
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SUBSCRIBE TO A NEWSLETTERDisclaimer: I am NOT a financial advisor. I’m using information sources believed to be reliable, but their accuracy cannot be guaranteed. The information I publish is not intended to constitute individual investment advice and is not designed to meet your personal financial situation. The opinions expressed in such publications are those of the publisher and are subject to change without notice. You are advised to discuss your investment options with your financial advisers, whether any investment is suitable for your specific needs. I may, from time to time, have positions in the securities covered in the articles on this website.
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