What Is The Poor Man’s Covered Call?
You’ve all heard of selling covered calls as a trading strategy, right? It’s Step 3 of the Wheel Strategy for trading options, and it is an excellent source of earning premiums. Today, I’m going to talk about the Poor Man’s Covered Call. I’ll be answering questions like:
- What is it?
- Who is it for?
- When to use it!
The Poor Man’s Covered Call is actually a very specific type of spread. As you know, I’ve covered several different types of option spreads in my Coffee with Markus sessions. We’ve even been covering Covered Calls and other options strategies on our YouTube channel which you can watch here!
In this article, I’ll be going over the differences between trading stocks, covered calls, and finally, the Poor Man’s Covered Call.
First, we’ll talk about trading stocks. For this example, I’ll be using Boeing (BA) as the stock I am bullish on. If you were a stock trader, you’d probably purchase a decent amount of stock. Let’s use a position of 100 shares for this example to keep things simple.
Boeing’s stock has had a rough year so far and the stock is currently trading at about $130 per share. If you purchased 100 shares of Boeing, then you’d be on the hook for $13,000 in buying power.
Let’s just go over the basics here: if Boeing’s stock price rises by $10 to $140, then you gain $1,000 in net profit. We can look at this as a situation of risking $13,000 to earn $1,000. This is all basic stuff and you probably already understand this concept.
Selling Covered Calls
Now, let’s continue to use Boeing for our Covered Calls example. Let’s say that in the short-term you expect the price of Boeing’s stock to rise which explains why you are bullish on the stock.
Since you already own 100 shares of Boeing’s stock, we can easily sell covered calls on our position. Let’s look at the $150 Call Option for Boeing.
If Boeing’s stock price rises to $140 like you expect it to, then we’ll earn an additional $450 in premium from selling our covered calls. This is in addition to the $1,000 you would have already earned from your underlying position. If we see a decrease in the stock price, the covered call will act as a hedge.
In this example, if we saw Boeing’s stock fall down to $120, then you would lose $1,00 on your initial position. But since we sold the $200 Call Option contract and banked the premium of $450, our net loss is actually only $550.
Here is a table to visualize these transactions:
|Trading Stocks||Covered Calls|
|Trade||100 Stocks @ $130||Sell $200 Call Option|
|Capital Required||100 x $130 = $13,000||100 x $130 = $13,000|
|Stock Up $140||$10 x $100 = $1,000||$1,000 + $450 = $1,450|
|Stock Up $150||$20 x $100 = $2,000||$2,000 + $450 = $2,450|
|Stock Down $120||$10 x $ -100 = $-1,000||$-1,000 + $450 = $-550|
Poor Man’s Covered Call
Now I’m going to show you the Poor Man’s Covered Call strategy but first, a brief introduction:
Why would you trade a Poor Man’s Covered Call?
That’s easy! You would use the Poor Man’s Covered Call when you don’t have the $13,000 to buy 100 Boeing shares. It’s called the Poor Man’s Covered Call for a reason!
When do you trade a covered call?
You would trade a covered call when you expect the stock to stay above the current price and move slightly higher. This is a bullish trade on the underlying stock.
So, instead of buying 100 shares of the stock, you would purchase a deep in the money call option at a later expiration date.
When looking for a call option that is deep in the money, we’re trying to find one with a Delta of around 0.95. This means for every dollar the stock moves, the call option is gaining .95 cents in value.
In this image, we can see the option price on the Boeing options contracts. This is where we will find the Delta and ensure that we’re choosing the right contract for the poor man’s covered call strategy.
Deep “In The Money” Calls
For this example, I’ll be using the deep in the money call which costs $71 per contract. As you know, with options contracts this means that I will only need capital of $7,100.
This is a fraction of the price of purchasing those Boeing shares outright. At the same time, we are also selling the $150 call option contract. Therefore, rather than owning the 100 shares, we are buying the deep in the money call option as well as selling the $150 call option.
If Boeing’s stock price moves from $130 to $140, then you would make about $1,335 because the Delta is 0.95, which means it is only increasing 95% of the value. The profit you see on this type of spread position is not as high as the covered call, but it is much more than owning the stock outright and requires much less risk and initial capital.
|Trading Stocks||Covered Calls||Poor Man’s CC|
|Trade||100 Stocks @ $130||Sell $200 Call Option||Buy $71 call|
Sell $150 call
|Capital Required||100 x $130 = $13,000||100 x $130 = $13,000||100 x $71 = $7,100|
|Stock Up $140||$10 x $100 = $1,000||$1,000 + $450 = $1,450||$1,335|
|Stock Up $150||$20 x $100 = $2,000||$2,000 + $450 = $2,450||$2,320|
|Stock Down $120||$10 x $ -100 = $-1,000||$-1,000 + $450 = $-550||$-675|
Conclusion: the Poor Man’s Covered Call Strategy
This sounds pretty good right? Almost too good to be true? I do have to warn you about a downside associated with this strategy.
If you use the Poor Man’s Covered Call Strategy, then your total profit is limited and even if Boeing’s stock sees a huge upward movement, you will only really benefit from a portion of the total gains.
For the example above, if the strike price gained $40, the stock trader would have earned $4,000 on their initial investment. The Covered Call trader would earn $2,450. Meanwhile, the Poor Man’s Covered Call would only earn $2,320.
A lot of traders use this strategy because it requires limited initial capital and therefore, there is also limited risk associated with a potential downward movement of the stock. It really is one of the safest ways to earn premiums on options contracts, especially when you do not have enough capital to buy a position of 100 shares.