Covered Call writing involves buying 100 shares of a stock or ETF and simultaneously selling a call on those shares. It is a very popular strategy for income investors and has the ability to produce outsize returns in flat, down and slightly up markets.
The issue for some investors is that the costs can be prohibitive, this is especially so for those with smaller accounts.
Take AAPL for example. With the stock trading around $170, an investor would need to have around $17,000 in order to trade just 1 covered call.
There can also be issues with diversification. With so much capital needed it can be very difficult for smaller investor to create a diversified portfolio.
A Poor Man’s Covered Call is a strategy designed to replicate a standard Covered Call trade, but with a much lower capital outlay. This strategy is also used as a reduced risk method of generating a similar return.
With a Covered Call position, the trade would be required to purchase at least 100 shares of the stock which could potentially tie up thousands of dollars in capital.
With the Poor Man’s Covered Call, a long-term, deep in-the-money call is used as a substitute for the 100 shares. Sometimes, this call can be purchased for a fraction of the cost of 100 shares and have a similar payoff.
Traders should be aware that this is basically the same as leveraging your portfolio. Gains and losses in dollar terms will be very similar between a standard covered call and a poor man’s covered call, but the percentage returns will be more amplified using the poor man’s approach.
ADVANTAGES AND DISADVANTAGES
The below table shows some of the advantages and disadvantages of the poor man’s covered call in comparison with a regular covered call.
BEST UNDERLYINGS FOR POOR MAN’S COVERED CALLS
Similar to regular covered calls, traders should focus on stocks they think will be neutral to slightly higher over the course of the trade.
Some traders (myself included) prefer trading stocks and ETF’s with lower volatility. As such, the P&L fluctuations won’t be as high on a day to day basis and the trade can be easier to manage. Each to their own though.
My preference is focussing on blue chip stocks that I am happy to own for the long term. Stocks in the Dow Jones Index for example area great place to start.
I also like using this strategy on ETF’s. Poor man’s covered calls are a great way to gain exposure to a particular region or sector. In the past I’ve used this strategy extensively on IYR and EEM.
ETF’s have no stock specific risk and they aren’t subject to earnings announcements. Therefore they are much less likely to suffer massive price moves based on a news event.
A simple portfolio could be created using ETF’s.
Let’s say an investor has the following target allocation:
The investor could then use these ETF’s and trade poor man’s covered calls. Let’s assume a portfolio size of $25,000:
CHOOSING STRIKES PRICES
Alan Ellman, The Blue Collar Investor suggests the following formula when trading poor man’s covered calls:
Difference between the 2 strikes + premium generated from the short call > cost of LEAPS
When choosing the long call there is a trade-off between how much capital you want to spend and how much time premium is embedded in the LEAP. We want to pay the least amount of time premium possible because time decay will work against us on the LEAP.
I like to look around Delta 0.70 to 0.80 for the LEAP and I always check how much time premium is embedded in those strikes.
The deeper in-the-money the LEAP call is, the less time premium it is likely to have. The less time premium it has, the more it will behave like the underlying stock.
For the short call, I like to be slightly out-of-the-money so that there is still some potential for capital appreciation in the trade. But, it also depends on the underlying stock. If I think the stock is going to be flat, I might consider an at-the-money call to increase the income portion of the position and forego any potential upside from the stock.
When selling the call, investors should aim to make sure the time premium in the short call is greater than the time premium in the LEAP. Usually this is not difficult.
The further in-the-money the investor goes with the LEAP call, the less time value, but the option will cost more.
HOW TO DEAL WITH EARNINGS REPORTS
Large drops (or gains) after earnings happen more frequently than is implied by statistical probability. For example, earlier this year, I ignored my rules and held a position on NWL over earnings, only to see the stock drop 25%. Ouch.
As I’ve said numerous times in the past, when it comes to earnings, it’s best to avoid them. For this reason I prefer sector and county ETF’s that are not subject to earnings announcements.
When trading poor man’s covered calls on individual stocks, it’s best to try and avoid earnings.
When it comes to adjustments, the process is very similar to that which you would employ for regular covered calls.
If the stock goes up, we will likely see some losses on the short call. That’s generally ok, because the long call will have gone up by a proportionate amount. In this case, there is probably no adjustment needed because we’ve made some good gains on the long call.
If the stock hasn’t blown too far through the short call, we can also think about rolling out in time and also rolling up, provided we can generate a decent credit.
If the stock has moved down, we can roll the call down to lower strikes. By doing this we can collect more premium and lower the capital at risk / max loss.
We can also roll out further in time if we want to generate a higher credit and we don’t mind being in the trade a bit longer. Time decay will pass more slowly on the longer-term short call however.
If the stock has gone down, we should also re-asses our assumption on the stock. Do we still want the exposure? Do we think it will rebound?
One benefit of the poor man’s covered call when the stock declines, is that implied volatility will likely have risen. This can mean the LEAP may not have declined as much because its value is being propped up by the higher implied volatility.
Rolling down means we can collect more premium when rolling the sold call. Or, we don’t have to move it as far to collect the same amount of premium.
If the stock moves to the sweet spot right around the short call at expiry, I generally keep the exposure and roll out to the next month. If I’m still bullish I may also roll further out in price to give myself some more capital gain potential.
If you can do this a few months in a row, you can significantly reduce your cost basis.
Generally, I leave the LEAP option alone. Spreads are wider with LEAPS so it can be hard to get filled at the mid-point which can get expensive if you are making multiple adjustments. For this reason I tend to leave the LEAP alone through the course of the trade.
POOR MAN’S COVERED CALL EXAMPLE
I’ll now walk you through a trade example from 2017. The trade worked really well, but there were a couple of mistakes I made, or things that I could have done better. See if you can spot them.
With this strategy, I like to avoid individual stocks and love the sector ETF’s. The example today is using IYR – the iShares US Real Estate ETF.
This is an instrument that I’m happy to hold for the long term. I always want to have some exposure to real estate in my portfolio.
Other than the 2008-2009 period, this ETF tends to have a slow and steady rise higher as you can see below. Since 2013, dips have been excellent buying opportunities. This type of setup is perfect for a poor man’s covered call.
Here are the details of the trade:
Trade Date: January 18th 2017
IYR Price: $77.73
Buy 5 18th Jan 2019 $68 Calls @ $11.89
Sell 5 17th March 2017 $80 Calls @ $0.94
Total Premium Paid: $5,475
If we check back to our formula, this fits our criteria:
Difference between the 2 strikes + premium generated from the short call > cost of LEAPS
The difference between the strikes is $12 + $0.94 premium received = $12.94 which is greater than the cost of the LEAP at $11.89, so we are good to go.
At this point IYR has risen slightly to $79.85, just below my sold call at $80. The trade is +$780 as the LEAP has risen to $13.28 and the sold call is also showing a small profit thanks to time decay. The sold call is trading for $0.86.
At this point there isn’t a huge amount of profit potential left in the trade, but I still wanted exposure to IYR. As such, I close out the March $80 call and roll it out to April $80.
By doing this I was able to bring in an extra $230 in premium.
Date: March 2nd 2017
IYR Price: $79.85
Buy 5 17th March 2017 $80 Calls @ $0.86
Sell 5 21st April 2017 $80 Calls @ $1.32
Premium Received: $230
Once again, the trade is working out well. A couple of weeks out from expiry and IYR is trading right at the short call. I take the opportunity to roll out again and bring in some more premium. This time I also roll up by $1 to give myself some more capital gain potential.
Rolling out to June and up to $81 brings in another $390 in premium.
The position is +$975 at this point.
Date: April 11th 2017
IYR Price: $80.01
Buy 5 21st April 2017 $80 Calls @ $0.40
Sell 5 16th June 2017 $81 Calls @ $1.18
Premium Received: $390
(note the graphs from here on are off slightly for some reason. On the upside it should slope slowly down to the right rather than being horizontal)
At the end of May, IYR had dropped back to $78.92 and my $81 June short calls were basically worthless. At this point I rolled the calls down to $79 and out to July.
This roll brought in another $430 in premium.
I’ve also gone backwards a bit in the trade due to the drop in IYR. Previously I was +$975, now the trade is back to +$720.
In hindsight, I was possibly a little aggressive rolling down the calls and didn’t give myself enough room for capital appreciation. Within a few weeks IYR was back up near $82.
Date: May 31st 2017
IYR Price: $78.92
Buy 5 16th June 2017 $81 Calls @ $0.06
Sell 5 21st July 2017 $79 Calls @ $0.92
Premium Received: $430
With IYR back up at $81.76 my short calls were well and truly in the money so I decided to roll up to $82 and out to August. This adjustment actually cost me $885 which was a bit painful.
If I hadn’t rolled the calls down so low in the previous step, I could have avoided some of this pain.
The loss on the July calls has been offset by gains in the LEAPS however and the whole trade is back to +$1,120.
Date: June 26th 2017
IYR Price: $81.76
Buy 5 21st July 2017 $79 Calls @ $2.69
Sell 5 18th August 2017 $82 Calls @ $0.92
Premium Paid: $885
By August 8th, IYR has dropped again to $79.95. The trade has gone backwards a little bit, but not too much thanks to the time decay on the August calls. The trade has gone from +$1,120 to +$945.
Again, I decided to roll down to the at-the-money strike of $80 and out another month to September.
Given that the August calls were almost worthless and the September $80 calls were trading for $1.22, I was able to bring in $585 in premium.
Date: August 8th 2017
IYR Price: $79.95
Buy 5 18th August 2017 $82 Calls @ $0.05
Sell 5 15th September 2017 $80 Calls @ $1.22
Premium Received: $585
Moving forward to September 1st, IYR has risen from $79.95 to $81.44 which has seen the position go from +$945 to +$1,270.
At this point, my September $80 calls are in the money and have very little time value left, so I decided to roll out to October and up to $81.
This adjustment cost me $190 but gave me more time premium.
Date: September 1st 2017
IYR Price: $81.44
Buy 5 15th September 2017 $80 Calls @ $1.62
Sell 5 20th October 2017 $81 Calls @ $1.24
Premium Paid: $190
IYR stayed pretty steady over the next 5 weeks and by October 16th was trading at $81.29, basically the same spot it was on September 1st. This was perfect for the trade and saw the position go from +$1,270 to +$1,685.
Over the 5 weeks, the short calls declined from $1.24 to $0.51 and the LEAP call held its value at $13.65. This is because there was very little time premium in the LEAP and theta decay is very slow on the long term options.
For this adjustment I decided to roll out to December and up to $83. This adjustment brought in $100 in premium.
Date: October 16th 2017
IYR Price: $81.29
Buy 5 20th October 2017 $81 Calls @ $0.51
Sell 5 15th December 2017 $83 Calls @ $0.71
Premium Received: $100
On December 16th I decided to close the position by letting the Dec $83 calls expire and closing the LEAP calls.
Total profit on the trade was +$2,055, not bad for a trade that only used $5,475 in capital!
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Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.