Poor Man’s Covered Call – What is it?

The Poor Man’s Covered Call (PMCC) is an options strategy that effectively mimics a traditional covered call position, but with a focus on capital efficiency. In a conventional covered call setup, an investor holds long stock to hedge against the risks associated with a short call.

In contrast, the PMCC utilizes a long-term call option instead of owning the underlying stock, making it a more accessible option for those looking to implement the strategy without substantial capital investment.

Investors typically employ the PMCC when they hold a neutral to bullish outlook on a stock or ETF. This strategy can be useful for expressing optimism about price appreciation or generating additional income even in a neutral market environment.

5 key takeaways

Cost-Effective Exposure: Discover how the Poor Man’s Covered Call (PMCC) provides a way to gain exposure to stock price movements without the substantial capital required for direct stock ownership.
Income Generation: Learn how to generate additional income by selling short-term call options against your long-term in-the-money call, effectively reducing your overall investment costs.
Risk Management: Understand the risk profile of the PMCC strategy, including potential losses and how to mitigate them compared to traditional covered calls.
Strategic Setup: Get step-by-step guidance on setting up a Poor Man’s Covered Call, including how to select the right underlying stock, call options, and strike prices.
Profit Potential: Explore the maximum profit and loss scenarios associated with the PMCC strategy, along with real-world examples to illustrate its effectiveness and practical application.

How Does a Poor Man’s Covered Call Work?

The PMCC operates similarly to a covered call while requiring significantly less capital. By purchasing a long-term in-the-money (ITM) call option, investors can gain exposure akin to owning 100 shares of stock, but at a lower cost.

With a long call, investors can sell a call option against it, which helps reduce the overall cost basis of the position, albeit at the expense of capping potential profits from the long call.

To structure a PMCC, you start by buying a long-term ITM call option—often a deep in-the-money LEAP—followed by selling a shorter-term out-of-the-money (OTM) call option on the same stock. This long call option serves as a substitute for owning the stock itself, allowing investors to participate in price movements without needing to purchase the shares outright.

The strategy earns its name because it involves a lower capital commitment compared to direct stock ownership. Ideally, the short call expires worthless, allowing the investor to keep the premium while the long call appreciates in value as the underlying stock rises.

Poor Man’s Covered Call vs. Covered Call

While both strategies share similar dynamics, the PMCC operates at a much lower capital requirement compared to a traditional covered call. In a typical covered call, an investor holds long stock to mitigate the risk associated with a short call.

The PMCC, however, replaces this stock with a back-month long call option, making it a more capital-efficient way to achieve similar results without actually owning shares.

In a traditional covered call, the structure is as follows:

• Long Stock: Owning 100 shares of the underlying asset.
• Short Near-Term OTM Call: Writing a call option on that same stock.

Conversely, the PMCC structure involves:

• Long Back-Month ITM Call Option: Buying a long-term call option, typically a deep in-the-money LEAP.
• Short Near-Term OTM Call Option: Selling a shorter-term call option on the same stock.

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How to Use a Poor Man’s Covered Call

Implementing a PMCC requires purchasing a deep ITM, back-month call option and simultaneously selling a shorter-term OTM call option on the same stock. Here’s how to do it:

1. Identify the Underlying Asset: Choose a stock or ETF that you expect to perform moderately well or maintain stability over the long term.
2. Buy a Back-Month Call Option: Purchase a deep ITM call option with an expiration date that is several months or years away. It’s crucial to select one with a high delta for better alignment with stock movements.
3. Sell a Shorter-Term Call Option: Choose a call option on the same asset with a shorter expiration date, generally between 30 to 60 days.
4. Manage the Position: Keep an eye on the position. Decide whether to let the short call expire, buy it back, or roll it to a later expiration date or different strike.

Max Profit Potential with PMCC

The maximum profit from a PMCC occurs when the underlying stock closes exactly at the strike price of the short call option upon expiration. This profit comprises:

• The premium earned from selling the short call.
• The increase in value of the long LEAP option as it appreciates to the short call’s strike price.

Max Profit Formula: Maximum Profit = (Strike of Short Call − Strike of Long LEAP − Price of Long LEAP + Premium Received from Short Call) × 100

Max Profit Example: Suppose Stock XYZ is trading at $150:

• You acquire a back-month call option with a strike of $120 for $30.00 (totaling $3,000).
• You sell a 30-day call option with a strike of $155 for a premium of $2.50 ($250 total).

Maximum Profit = (155 − 120 − 30 + 2.50) × 100 = $750

Max Loss Potential with PMCC

The maximum loss in a PMCC primarily comes from the long back-month call option. If this option expires worthless, it represents your total loss.

Max Loss Formula: Maximum Loss = Cost of Long Call − Premium Received from Short Call

Max Loss Example: If stock ABC is trading at $80:

• You purchase a long-term ITM call option with a strike of $60 for $25.00 (or $2,500 total).
• You sell a 30-day OTM call option with a strike of $85 for a premium of $3.00 (or $300).

Maximum Loss = ($25.00 − $3.00) × 100 = $2,200

How to Estimate Max Profit / Breakeven

Calculating the exact maximum profit and breakeven points for a PMCC can be complex due to the varying expiration dates of the options. However, you can estimate these values with the following formulas:

Max Profit: Maximum Profit = Width of Call Strikes – Net Debit Paid

Breakeven Point: Breakeven = Long Call Strike Price + Net Debit Paid

What Happens if a Poor Man’s Covered Call is Assigned?

Assignment in a PMCC occurs when the holder of the short call option exercises their right, typically when the short call moves in-the-money (ITM). The process differs from a traditional covered call:

1. Exercise the Back-Month Call Option: If your long call is deep in-the-money, you can exercise it to acquire 100 shares of the stock, offsetting your short position.
2. Buy 100 Shares and Sell the Long Call: Alternatively, you can purchase 100 shares on the open market to cover your short position and then sell the long call to exit the trade.

Can You Lose Money on a Poor Man’s Covered Call?

Yes, there is potential for loss with the PMCC strategy. Although this method generates income through selling call options, several factors can lead to losses:

• Decline in Stock Value: The primary risk arises if the stock’s value drops significantly. Even with the premium from the short call, it may not be enough to cover substantial declines in the stock price and the long call option.
• Opportunity Loss: If the stock exceeds the strike price of the short call, you forfeit gains above that price since you’re obligated to sell at the strike price.
• Early Assignment: With American-style options, early assignment can occur, particularly if the short call is in-the-money and dividends are anticipated. This may require you to adjust your position sooner than expected.

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Summary of the Poor Man’s Covered Call Strategy

The Poor Man’s Covered Call (PMCC) replicates a covered call strategy by using a long-term in-the-money (ITM) call option instead of holding the actual stock. This approach offers a capital-efficient alternative to traditional covered calls, appealing to investors with a neutral to bullish outlook on a stock or ETF.

The strategy aims to lower the cost basis of the long call by selling short-term call options, ideally resulting in the short call expiring worthless, allowing the investor to keep the premium while benefiting from the appreciating value of the long call as the underlying stock price rises.

Frequently Asked Questions

Q1: What is a Poor Man’s Covered Call?
A Poor Man’s Covered Call (PMCC) is an options strategy that replicates a covered call position using a long-term in-the-money call option instead of owning the stock.

Q2: What are the benefits of using a Poor Man’s Covered Call?
The PMCC requires less capital than traditional covered calls, allows for income generation through sold call premiums, and offers flexibility in managing trades.

Q3: How do I set up a Poor Man’s Covered Call?
To set up a PMCC, buy a long-term ITM call option and sell a shorter-term OTM call option on the same stock. Monitor the position for adjustments.

Q4: What is the maximum profit and loss potential with a PMCC?
Maximum profit occurs if the stock closes at the strike price of the short call, while maximum loss is limited to the cost of the long call minus any premium received.

Q5: Can I lose money using a Poor Man’s Covered Call?
Yes, potential losses can arise if the stock declines significantly or if the price exceeds the strike price of the short call, leading to missed gains.

Conclusion

The Poor Man’s Covered Call is an efficient way to engage in the covered call strategy, enabling you to enjoy its benefits without the need for stock ownership. With a lower capital requirement and associated risks, it serves as a valuable tool for investors looking to generate extra income or maintain a moderately bullish stance on a stock or ETF.