Covered calls, when used correctly, are possibly one of the best options strategies available to retail investors. However, the biggest weakness of covered calls is that they require a significant amount of capital. Fortunately, there is an options strategy that affords an investor virtually all the benefits of a covered call, but with a fraction of the capital requirement. This strategy is called the Poor Man’s Covered Call (PMCC). A Poor Man’s Covered Call is technically called a long call diagonal debit spread that effectively replicates a covered call position. The main benefit of using this strategy is that you can generate monthly income from writing a covered call without having to purchase 100 shares of the underlying security. In a traditional covered call, you purchase 100 shares of an underlying security and simultaneously sell a short dated call at a strike price that is out-of-the-money.
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By selling the short call, you receive a premium from the buyer of the call. Ideally, the share price closes below the strike price on the expiration date and you pocket the premium sold. If the share price closes above the short call strike price, the buyer of the call will exercise his option and purchase the 100 shares at the strike price. You will then be forced to sell your shares and in return receive the strike price plus the original premium received. Even if the shares rise significantly above the strike price you’ll not participate in any of the upside. Your return will be capped by the strike price of the short call. A covered call strategy is considered highly conservative and is even allowed to be undertaken in retirement accounts.
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The main downside of the covered call strategy is that is requires a significant amount of capital. For example, SPY (a popular S&P 500 index ETF) is currently trading at $424.5. If you wanted to write one covered call on SPY you would have to purchase 100 shares for $42,450. Most investors don’t have enough capital to write covered calls and still maintain adequate diversification in their portfolio.
The main benefit of the PMCC strategy is that you can still sell a covered call but purchase a call option instead of 100 shares to cover the position. Purchasing a call option requires significantly less capital, thus increasing your leverage and ultimately your returns.
How Do You Enter Into a PMCC Trade?
You enter a PMCC trade by purchasing a long dated call option and then selling short a short-dated call option on the same underlying security. I prefer to purchase LEAPS for the long leg of a PMCC trade. This allows you to control the position for a longer time and affords you the opportunity to sell more premium. Additionally, by purchasing a LEAPS option you minimize the impact of theta on your position. All options have expiration dates and slowly lose value over time. Theta is one of the options “Greeks” that measures the impact of time decay on the underlying price of an option. By purchasing a LEAPS with an expiration date that is more than a year out, you can minimize the loss from time value. Additionally, you want to purchase a call option that has a relatively high delta, which measures the change in price of the option from a $1 change in the price of the security. Since you are purchasing a LEAPS call option it will increase in value as the price of the underlying security increases. At the same time, you’re selling short an out-of-the-money call option that has 30-40 days till maturity. For the option that you sold short, you will lose money as the price of the underlying security increases. You want to avoid a scenario where the gains from the long call option are completely offset by the losses on the short call option that you sold. If you implement the strategy incorrectly you could end up losing money even if the underlying security increases significantly in value.
Once you enter the PMCC trade there are basically two main scenarios that can occur. Either the underlying stock rises above the strike price of the short dated call or it stays below on the expiration date. In the instance the share price stays below the short call strike price, you simply keep the premium that you originally received and sell another short dated option with 30-40 days till maturity. You can keep selling premium for up to 8-10 times assuming you purchased a LEAPS call option with at least one year to maturity. In the event the share price of the underlying rises above the strike price of the short call, you can simply close out your position for a gain by selling to close the long LEAPS call and buying-to-close the short dated call. Since you purchased a LEAPS call with a higher delta than the call you sold short, you will make more money on the underlying LEAPS position than you will lose on the short-dated call that you sold.
A Case Study on Philip Morris International (PM)
On April 15, 2021 I bought to open a January 20, 2023 77.5 call for $17.19. One call option allows you to control 100 shares . I bought a contract with essentially a little less than two years to maturity. At the same time, I sold to open the May 8, 2021 100 call for $1.13. On that same day PM’s share price closed at $91.83. In order to enter into a covered call transaction, I would have had to purchase $9,183 worth of shares. By using the LEAPS call, I was able to enter the long leg of the trade for $1,719, a 81% reduction in the amount of capital required. Furthermore, I received $1.13 in premium for an initial return on my investment of 6.5% with less than one month till maturity. Furthermore, by utilizing a PMCC trade our max loss was reduced to $1,606 ($1,719 LEAPS contract minus $113 call). In comparison, in a traditional covered call strategy our max loss would be $9,070 ($9,183 – $113).
On May 6, 2021 I subsequently bought back the short call for $2.08 and sold a second short-dated June 11, 2021 99.5 call for $0.83. Roughly a month later, I bought-to-close the June 11, 2021 call for $0.05 and sold the July 16, 2021 100 call for $0.60. In total, I received $256 (100 x $2.56) in premium and paid a total of $213 ($2.13 x 100) to close out positions. At the same time, my initial LEAPS increased in value from $17.19 to $23.47, a gain of $628 ($6.28 x 100). Thus, my total return from the position as of June 15, 2021 was 39.0% [($628 + 256 – 213)/ $1,719]. In comparison the share price went from $91.83 on 4/15/2021 to $100.46 on June 15, 2021 an increase of only 9.4%. Due to the leverage inherent in the PMCC trade, I was able to produce a 4x return relative to the share price performance.
Additionally, if the shares didn’t rise above the strike price of my short call, I would’ve had the opportunity to continue selling premium and further reducing my cost basis on the LEAPS contracts. Eventually, we would near the LEAPS contract’s expiration date and I would be able to sell the contract and use the proceeds to roll over the position. Thus, the strategy can be continued indefinitely by rolling out the LEAPS contract. The PMCC allows you to enhance returns in comparison to just purchasing the stock outright. The leverage inherent in the trade magnifies returns on both the upside and downside. Ideally, you want to enter PMCC trades on high-quality blue-chip stocks with lower volatility in comparison to the overall market. The foundation of the strategy is still a covered call, which is highly conservative. By combining the conservativeness of a covered call with leverage, you can generate higher returns with relatively low risk in comparison to simply purchasing the stock outright.
|4/15/2021||LEAPS January 20. 2023 77.5 call||$17.19||Buy-to-Open|
|4/15/201||May 8, 2021 95 call||$1.13||Sell-to-Open|
|5/6/2021||May 8, 2021 95 call||$2.08||Buy-to-Close|
|5/6/2021||June 11, 2021 99.5 call||$0.83||Sell-to-Open|
|6/9/2021||June 11, 2021 99.5 call||$0.05||Buy-to-Close|
|6/9/2021||July 16, 2021 100 call||$0.60||Sell-to-Open|
Article by Ankur Shah, Ashva Capital