Navigating the field of options can be incredibly difficult sometimes. It gets even more difficult when you realize how much capital is required for some of the fancier plays. Today we are going to be taking a look at a poor man’s covered call. This allows you to create a synthetic covered call for a much lower capital requirement. If you are looking for alternatives to the Wheel Strategy, you might want to take a look at this trade.
What is a Poor Man’s Covered Call
A poor man’s covered call is sometimes referred to a synthetic covered covered call. It involves buying a call that is in-the-money further away from expiration while simultaneously selling a call that is out-of-the-money that is closer to expiration. The longer dated call creates the ‘cover’ for the shorter term contract that you are selling.
For a normal covered call you have to own 100 shares of the underlying which can be costly. In this example, our initial cost is the difference between the premium that we have to spend for long contract and the credit from the short contract. This is generally a much smaller amount than buying 100 shares outright.
The synthetic covered call is really just a diagonal call spread with the goal to create monthly credits for a much lower capital requirement.
Setting up a Poor Man’s Covered Call
Anytime we are setting up a covered call, we are hoping to take advantage of short term neutral trends to collect premium. This allows us to sell calls that are slightly out of the money for decent premium, without worrying about assignment risk. For our short call we are looking to go between 30-45 days to expiration in order to generate premium and offset the initial debit outlay for a long call.
As far as our long call goes, there are some things to consider. The first is how far we want to go out. We are generally going to use LEAP (Long-term Equity Anticipation) contracts. These are option contracts with a year or more to expiration. The first thing we want to look for is enough volume to execute our trade. The deeper in the money and the longer to expiration is, it may be more difficult to find a trade. We are also going to look for a Delta around .90 so that way we can take advantage of stock movements.
Poor Man’s Covered Call Example
To give you an example of a covered call I will tell you about my most recent trade. I executed this trade roughly a week ago from this publishing. I choose the underlying of AT&T. For the long call I am using a strike price of $25 and a short call strike price of $30.5.
For my long call I choose the January 21st 2022 expiration date and paid $5.59 for this trade. The current delta is .8255. The short call I choose the expiration of August 21st 2020. For this trade I received $0.24. This gives me a total debit of $5.35.As long as $T is below $30.5 on August 22nd then I can keep the $0.24 premium and write another contract for the next 30 days.
While we are rolling these trades, we aren’t entirely concerned if $T rises above $30.5. If it does we will sell 100 shares for $30.5 each netting us $3,050. Then we will execute our long contract for $25.00 and buy the shares for $2,500. This gives us a net benefit of $550. Given our initial trade was only a debit of $5.35 costing us $535, we will still be making money if our trade gets called away.
The Benefits of the Poor Man’s Covered Call
As you can see from the above example, it only requires $535 of capital to execute the trade. On the other hand, if I were to buy $T outright at the time it would have costed $2983. This is almost a fifth of the capital requirement and can lead to even more profit.
The other benefit of this trade is the defined risk. We are really only risking our initial capital outlay. With stock ownership, our shares can go to $0. With our option contracts, we have the advantage of defining how much we are willing to lose.
The downside of this trade is the defined benefit. We achieve maximum benefit when the trade goes above our short call strike price. When this happens we receive the premium from the short call, minus the premium from the long call plus the difference between strike prices.
Have you ever employed a poor man’s covered call? Let me know in the comments below!