Some of you might have heard of the term “covered call”, an options strategy that aims to generate a steady stream of income every month. However, do you know of its alternative, the “Poor Man’s Covered Call” strategy which is targeted at investors who “are poor”, or who do not wish to commit a large amount of capital?
The poor man’s covered call strategy allows one to enjoy the benefit of leverage (getting exposure to stocks at potentially > 50% discount) while generating a steady stream of “passive income” if done appropriately.
Poor man’s covered call strategy
The key differentiating point between the poor man’s covered call strategy vs. the traditional covered call strategy is that the former does not entail the purchase of (at least) 100 shares of the stock.
The poor man’s covered call strategy involves the purchase of 1 call option and the sale of 1 call option. This strategy is similar to an option Vertical/spread. However, the difference is that both options have different expiration dates.
Poor Man’s Covered Call = Buy 1 Long Duration Call Option + Sell 1 Short Duration Call Option
Let us see how should one structure a standard Poor Man’s Covered Call using META $Meta Platforms, Inc.(META)$ as an example.
First, the BUY leg of the call option will generally entail the purchase of a long DURATION Deep-ITM option, one which typically has a Delta of at least 0.80 or higher. An option that has a delta of 1.0 essentially replicates the price movement of the underlying exactly, ie: if META price moves from $145 to $150 or a $5 movement, the price of the option will also move by $5.
If the option has a delta of 0.80, that means a $5 underlying META price movement will translate to an option price movement of 0.80*$5 = $4.
What we want to purchase is an option that essentially “mimics” the price movement of the underlying shares. So instead of owning the shares outright, we can essentially own a long-duration call option contract at a fraction of the cost (> 50% discount) of 100 shares of the underlying.
Let's focus on the META option chain with 509 days to expiration. The strike price of 115 has a delta of 0.81 (considered deep-ITM) and that particular option cost approx. $55.85/share or $5,585/ option contract to own. Compare to owning 100 shares of META at a total cost of c.$15,000, that is almost a 62% cost reduction while yet still essentially “owning” 100 shares of META (each option contract equates to 100 shares exposure).
For this particular option which has a delta of 0.81, if META price moves from $150 to $155 or a $5 movement (ROI of 3.3% if one purchases the stock), the option price will move by approx. 0.81 * $5 = $4.05 from $55.85 to $59.90 or a return on capital of 7.2%.
Second, the buy leg of the option, besides being deep ITM, typically also entails one that has a long expiration. In the above example, the expiration period is 509 days which is considered relatively long. META has long-dated options available until Jun 2025.
Third, for the SELL leg of the call option, it typically consists of a “short-dated” contract (47 days, etc in this example). The reason why the sell leg of the call option is one that has a short Day-to-Expiration (DTE) is to take advantage of Theta or Time Value Decay.
Theta decays happen the fastest in the last month (left with 30 days) of the option contract, that is why as the Seller of the contract, one will benefit the most from the rapid theta decay of the option contract since the investor has already “pocketed” the premium and will want this number to hit ZERO as fast as possible (Sell high and buy back low or ideally at zero).
Fourth, the SELL Leg of the call option typically consists of one that is Out-of-the-money (OTM), ie, the strike price is above the current underlying META’s share price of $150. In our example, we selected to sell the call option at the strike price of $175.
For the BUY leg, one can select a strike price with a Delta value of at least 0.80 or higher (Deep ITM) as a rough guide. This figure balances one’s capital outlay vs. replicating the underlying price performance.
For the SELL leg, which is the right strike price to sell?
There is honestly no “right” strike price. If one has a targeted “fair value” for META in mind, that might be the level at which the investor can structure the Sell Leg. For example, if an investor believes that $175 is the fair value of FB, then he/she can structure a Sell leg with a strike price of $175.
In our example above, selling an option with a strike of $175 generates a premium of $310/contract with a contract duration of 47 days. Do note that the investor risk not participating on the upside of META above the $175 level.
Alternatively, one can also look at the chart and base the Sell strike on the resistant level of the stock.
META Poor Man’s Covered Call
So assuming I wish to structure a poor man’s call option for META, I could purchase the Strike 115 Call Option that expires in 509 days-time, costing me $5,585 while concurrently selling the Strike 175 Call Option that expires in 47 days-time, generating me an income of $310.
If META price stays below $175 on the expiration date in 47 days-time, my call option which I sold expires worthless and I get to pocket the full amount of $310. In this case, my “yield on cost” is 310/5,585 = 5.5% over 1 month. I can then repeat the same process of selling another call option contract for the next month and pocket another round of premium.
Compared to the traditional covered call strategy which entails a capital of $15,500, the ROI potential using the Poor Man’s Covered Call strategy will be much higher (Covered Call: Annual ROI = 24%, Poor Man’s Covered Call: Annual ROI = 66%)
What happens if META price is above the Sell Call strike on expiration?
For the Poor Man’s Covered Call, because the investor does not “directly” own 100 shares of META but has an indirect exposure through the 1-long DTE (509 days) Call option contract, if the price of META exceeds the Sell Strike of $175 on the short call expiration (47 days), he/she will be forced to “sell short” the shares of META at a strike of $175.
This means that his final exposure will be: +1 Long Call META contract and -100 META shares
In this scenario, it will be appropriate for him to close off both his long META call option and negative shares together and book his profit.
Assuming META price closes at $190 on 17th Mar. His “Short Stock” position will incur a loss of ($190-$175)*100 = -$1,500 (losses)
His Long Call Options contract, which he originally purchased at $5,585 (strike $115) will now be worth around $8,500 (Intrinsic value of $7,500 (($190-$115)*100 shares) + time value of $1,000) which he can sell in the open market.
His profit from his Call option is $8,500 – $5,585 = $2,915
So his total net profit = $2,915 (long call option) – $1,500 (short stock) + $310 (premium from selling the call option) = $1,725
On an initial capital of $5,585, that represents an ROI of 31% over a horizon of just 47 days. On an annualized basis, that is an ROI of 240%.
Conclusion
Not all stocks should be executed with a poor man’s covered call strategy or at least my preferred choice in choosing the type of stocks are those that are generally more stable (beta at 1 or below) or less volatile. This lowers the likelihood of the price spiking above the Sell Call strike which will allow me to continuously sell call options in the forward months.
Note that if the price appreciates significantly above the sell call strike, one might no longer be able to participate in further upside in the underlying counter.
For high-dividend stocks, do note the following. As a Call Option Holder, you are NOT a shareholder of the company and will not be entitled to any dividends declared. When a dividend goes ex-dividend, it will “typically” benefit the Sell Leg of the Call (although this is generally already priced into the option value).
Do check out this strategy if you are considering purchasing at least 100 shares of a counter in the first place.
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