What is a poor man’s covered call and why is it better than a covered call?


To answer this question let’s first look at what a covered call is.

What is a covered call?

A covered call is when you buy (or already own) at least 100 shares of stock and you want to generate income by selling call options against the stock that you own.

EXAMPLE:

You believe that Microsoft Corporation (MSFT) stock is going to continue to trend up long term so you purchase 100 shares today at $309.61 (the present cost of the shares). This means you invest $30,961 in the stock. You could then turn around and sell Out-of-the-money call options on the stock to generate income.

Let’s assume that you decided to start selling calls with a strike price of $320 per share. Looking at the next weekly option, as well as one that is about two weeks before out before expiration, and one that is about a month out before expiration, this is the money you could generate:

  • The October 29, 2021 option would provide an income of $0.97 per share. Since one contract is valued at 100 shares this would be an immediate income to your portfolio of $97.00.
  • The November 05, 2021 option would provide an income of $1.53 per share. Since one contract is valued at 100 shares this would be an immediate income to your portfolio of $153.00.
  • The November 19, 2021 option would provide an income of $2.63 per share. Since one contract is valued at 100 shares this would be an immediate income to your portfolio of $263.00.

Now let’s look at this over a one year timeframe. As you read through this remember that nothing remains the same in the stock market … stocks are either increasing in value or decreasing in value … but I want you to think for these purposes that everything remains the same so that you get the point.

Naturally as the stock goes up in value you will have to increase your strike price of the options so the stock does not get “called” away from you. However, that would not be all that bad considering you paid $309 per share and it would be called at $320. But the idea is to create a consistent form of “cash flow” to the account.

Looking out at a one-year timeframe your cash flow (if you received the same money every time you sold a call option) should be as follows:

  • $97 per week for 52 times in a year would be $5,044. The return on your 100 shares of stock that cost you $30,961 would be 16.29% if the price of the stock does not change and we disregard any dividends it may pay to own the stock. MSFT does provide an annual dividend of $2.48 per share or a current dividend yield of 0.80%.
  • $153 every two weeks for 26 two-week periods would be $3,978. The return on your 100 shares of stock that cost you $30,961 would be 12.84% if the price of the stock does not change and we disregard any dividends it may pay to own the stock.
  • $263 per month for 12 months would be $3,156. The return on your 100 shares of stock that cost you $30,961 would be 10.19% if the price of the stock does not change and we disregard any dividends it may pay to own the stock.

Naturally, the price of the stock is going to change from time to time – and if is going up then the premiums you receive from the call options you sell will go up – and if it is going down then the premiums you receive from the call options you sell will go down.

Many investors sell call options on stock they own or want to own to increase overall returns – especially when growth stocks pay little to no dividend.

So, what happens when you don’t have $30,961 in the investment account … or do not want to have that much money riding on one stock? You can use the “Poor Man’s Covered Call.”

What is a Poor Man’s Covered Call

The technical name is nothing more than a Diagonal Spread using two or more options. Let’s take a look:

Example: You purchase a deep in the money call option and use this as your backing (or cover) to sell Call Options against. Most brokerage firms will not allow common investors to do what is called a “Naked Call.” That is to sell a Call option with nothing to back you up or cover you against the downside risk. For instance, if you sold a call option on MSFT at a strike price of $310 per share and something happens in the company to cause the stock to drop to $200 per share while you had the call options outstanding … you could be forced to purchase the stock for $310 and sell it for $200. That is not a winning proposition by any means. On this one contract transaction you could lose up to $11,000 less any premium you may have received [($310 – $200) x 100] = 11,000.

With a Poor Man’s Covered Call you would purchase a long-term deep In-the-money call option. Let’s assume you decided to purchase the January 20, 2023 Call Option on MSFT with a strike price of $265 per share when today the stock is selling for $309.61 per share. This call option would cost you $62.60 per share or a total of $6,260 since one contract is worth 100 shares of the stock.

While this seems like a lot of money … it is not near as much as $30,961 that the actual stock would cost you. For a fraction of the cost (about 20%) you would still be in control of 100 shares of MSFT stock. The only downside is that you would not have voting rights or any dividend (both of which on this stock for a holder of 100 shares is almost worthless anyhow).

Now because you hold “1” Call contract the broker will allow you to sell weekly, bi-weekly, monthly or longer term options to generate income and still have coverage in the amount of $265 per share. Take a look at the returns you could generate on a smaller investment of $6,260:

  • The monthly $320 strike price option could provide as much as $263 per month or $3,156 over the course of one year. This would be a return of 50.4% on your initial investment of $6,260 as compared to 10.91% on an investment of $30,961 to purchase the stock to cover the option.
  • The bi-weekly $320 strike price option could provide as much as $153 every two weeks or about $3,978 over a period of one year. This would be a return of 63.5% on your initial investment of $6,260 as compared to 12.84% on an investment of $30,961 to purchase the stock to cover the option.
  • The weekly $320 strike price option could provide as much as $97 every week or about $5,044 over a period of one year. This would be a return of 80.5% on your initial investment of $6,260 as compared to 16.29% on an investment of $30,961 to purchase the stock to cover the option.

What would happen with more options like this?

Assume you had $31,000 in an account and decided you liked this stock and this idea. You could actually purchase 4 contracts (400 shares) and still hold $5,960 in cash and quadruple your cash flow into the account. This means at the end of one year …

  • With monthly options your account would grow by ($263 x 4 x 12) + $25,040 = $37,664 to a total value (with the additional cash of $5,960) of $43,624 (and we have not even considered the value of the Call Options you bought – only the cost of those options).
  • With bi-weekly options your account would grow by $153 x 4 x 26 + $25,040 = $37,664 to a total value (with the additional cash of $5,960) of $46,912 (and we have not even considered the value of the Call Options you bought – only the cost of those options).
  • With weekly options your account would grow by $97 x 4 x 52 + $25,040 = $45,216 to a total value (with the additional cash of $5,960) of $51,176 (and we have not even considered the value of the Call Options you bought – only the cost of those options)

Now if the stock did go to $320 between now and one year from now … those Call Options you purchased for $62.60 per share would have a value greater than what you paid for them. How much more is hard to tell since at the time of purchase there would have been “intrinsic value” of $44.61 per share that will continue to grow as and if the stock goes up in value and $17.99 of “time value” that will continue to shrink each day that you hold the option. We will look at a couple of risk graphs below.

Intrinsic Value is determined by subtracting strike price of the option from the market price of the stock ($309.61 – $265 = $44.61) in this case. If the value is negative it is considered $0.00. Time Value is determined by subtracting the Intrinsic Value from the total option premium. The remaining amount is Time Value ($62.60 – $44.61 = $17.99) in this case.

As these two “risk graphs” below show … if the MSFT stock only goes to a price of around $320 by expiration or before, then the gain on the option would only be about $707 or so. If the price went to $350 by January 2023 or before then the gain could be as high as $3,245.

Summary

If you are looking for income and don’t have a lot of money … consider looking at Deep in the money long-term options and selling shorter-term out of the money options on your long term option. THE POOR MAN’S COVERED CALL

If you are looking for growth of capital and don’t have a lot of money (or even if you do) consider longer-term At-the-money or Out-of-the money Call options.

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