Poor Man's Covered Call: The Ultimate Beginner's Guide

Views 2444Mar 8, 2024

Covered calls are a common options strategy. However, they are known for being expensive because a traditional covered call requires investors to own at least 100 shares of the underlying stock.

In contrast, a poor man’s covered call (PMCC) reduces this initial investment and makes it easier to execute. Below, moomoo explains how the PMCC works and how it could be utilized in an options trading strategy.

What Is the Poor Man’s Covered Call (PMCC)?

A poor man’s covered call (PMCC) is a bullish options strategy designed to replicate a traditional covered call position. A PMCC can also be classified as a “diagonal debit spread,” which refers to a call spread involving two different expiration periods.

Poor Man’s Covered Call vs. Covered Call

How does a poor man’s covered call differ from a traditional covered call? In a traditional covered call, an investor must buy 100 shares of stock before shorting an out-of-the-money (OTM) call option against the shares.

In a poor man’s covered call, investors replace the shares of stock with a deep in-the-money (ITM) long call that has a longer expiration term than the short call. As a result, investors generally spend significantly less money executing the PMCC while reducing the maximum loss potential as well.

How Does the Poor Man’s Covered Call Work?

The following shows you how to set up and perform a poor man’s covered call.

Setting Up a PMCC

To set up a PMCC, you’ll need to take two steps:

Buy an ITM call option with a long expiration date, for example, 90 days.
Short an OTM call option with an expiration date sooner than the ITM call above.

These actions will provide you with a long call that has a longer-term expiration date than the short call.

Here’s an example:

Buy a 140 call option in the July 2023 expiration cycle (110 days to expiration (DTE)), paying $25 premium for the option ($2,500 capital outflow). The stock’s share price is $160. Short the 170 call in the May 2023 expiration cycle (60 DTE), receiving $3 premium for the option ($300 capital inflow). The stock’s share price is $160.

Theoretical Maximum Profit

The maximum profit potential of a poor man’s covered call is calculated using the following equation:

Max Profit = Width of call strikes – Trade cost

It may help to use an example. Suppose that you set up a PMCC by purchasing a width of call strikes ($170 - $140 = $30) with the trade cost ($25 -$3 = $22). The max profit now comes to ($30 - $22 = $8). Remember to then multiply by 100 since each standard options contract typically represents 100 shares.

Don’t forget that the short call will expire before the long call. If this happens, and the trader does not close the long position, the trader effectively holds a long-call position, which could offer additional profit potential.

Theoretical Maximum Loss

The maximum loss of a poor man’s covered call is the cost of executing the trade. In the preceding example, the underlying asset could remain below the call strike prices and expire worthless. But that only means that the trader would be out the initial cost of setting up the call, which in the example was $22.

Time Decay

Options traders describe the impact of time using the measurement “theta,” which relates the change in an option’s premium relative to the passage of time. In a PMCC, positive theta occurs when the position value increases over time.

A negative theta occurs when the position value declines with time. Ideally, traders want to see a positive theta; otherwise, they will incur losses in the trade.

Strike Prices

One of the most difficult steps in setting up a call is determining the appropriate strike price — especially if you’re a beginner trader. But the following tips can help:

Consider buying a call with a delta above 0.75 and a day-to-expiration of at least 90 days.
Consider selling a call with a delta below 0.35 with fewer than 60 days to expire.

Essentially, you want to buy a deep-in-the-money (ITM) call while shorting an out-of-the-money (OTM) call. That said, you can adjust this strategy depending on how you set up the call.

Managing and Closing PMCC

As time passes, the short call may remain OTM, at which point the trader can buy back the call for a profit. They can subsequently short a new call option in the next expiration cycle to try and collect even more.

If the short call’s extrinsic value drops to zero, the position will have reached the greatest potential for profit, at which the trader can attempt to close the PMCC.

Once the ITM call approaches expiration, the trader will need to close or roll it over.

Note: Rolling involves closing an existing position and realizing gains or losses, while also opening a new position. Rolling options doesn’t ensure a profit or guarantee against a loss. You may also end up compounding your losses.

Possible Advantages of Poor Man’s Covered Calls

Traders value poor man’s covered calls for several reasons:

They cost less than a traditional covered call.
They offer less risk than a traditional covered call.
They require less maintenance for the long call.

Risks and Limitations of Poor Man’s Covered Calls

At the same time, there are some risks and limitations associated with PMCCs, such as:

It’s not always possible to predict price movements within expiration dates.
Options held for less than a year would be subject to capital gains tax.
PMCCs generally work better for companies with limited volatility.
Call options have fixed expiration dates, requiring careful selection aligned with the expected move in the underlying asset--while short calls limit upside potential and may forfeit gains beyond the strike price.
Replacing long stock with a call option means foregoing dividend payments, impacting potential income despite capital conservation.
There is risk of early assignment with the short call--something a covered call does not have.

Less Capital, But More Complexity

Options traders typically consider a covered call more of a beginner’s strategy, but a traditional covered call requires being long 100 shares of the underlying stock so it can carry considerable risk. A poor man’s covered call lowers the entry point for traders with less capital required but a spread trade is often more complex vs a covered call’s single leg.

Frequently Asked Questions About Poor Man’s Covered Call

Is a poor man’s covered call a good strategy?

While “good” depends on your goals and experience level, a PMCC does offer lower cost and risk levels than a traditional covered call, though it still requires traders to monitor the entire trade carefully.

How does a poor man's covered call make money?

In a PMCC, ideally the short call expires worthless, but the trader has kept the premium. The underlying asset’s value has progressively increased, raising the long, far-dated call option. This can contribute to the profit potential.

Options trading entails significant risk and is not appropriate for all customers. It is important that investors read Characteristics and Risks of Standardized Options (https://j.us.moomoo.com/00xBBz) before engaging in any options trading strategies. Options transactions are often complex and may involve the potential of losing the entire investment in a relatively short period of time. Certain complex options strategies carry additional risk, including the potential for losses that may exceed the original investment amount. Supporting documentation for any claims, if applicable, will be furnished upon request.