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Investor Education Series: Poor Man’s Covered Call

Some of you might have heard of the term “covered call”, an options strategy that aims to generate a steady stream of income every month. However, do you know of its alternative, the “Poor Man’s Covered Call” strategy which is targeted at investors who “are poor”, or one who does not wish to commit a large amount of capital?

The poor man’s covered call strategy is a relatively “low-risk” option strategy which allows one to enjoy the benefit of leverage while potentially generating a steady stream of “passive income” if done appropriately.

Before I go into the details of what a poor man’s covered call strategy is all about, let me briefly run through the basics of a “covered call” option strategy.

The Covered Call Strategy

The covered call strategy combines the purchase of shares as well as the usage of options. To trade a covered call on a particular stock, an investor would need to purchase at least 100 shares of the stock.

Let’s take for example the shares of Facebook (FB), currently trading at $275/share. To own 100 shares of FB will entail a capital outlay of $275 * 100 shares = $27,500. That is a pretty hefty amount for a typical investor.

Assuming that an investor has at least 100 shares of FB, he can then execute the covered call strategy to SELL 1 CALL option contract on FB at a particular STRIKE price (note that each option contract represents 100 shares of the underlying, that is why the investor will need to own at least 100 physical shares).

So what does selling 1 Call option contract mean to the investor? By being a SELLER of the call option contract, the investor is entitled to a premium of $x. This is money that goes straight into his pocket. However, after receiving this premium, the investor now has got an OBLIGATION to potentially fulfill. What is this obligation exactly?

Assuming that the current price of FB is $275. He bought $100 shares for a total cost of $27,500 and SOLD 1 Call Options contract at a STRIKE price of $300 for a contract with an expiration on 20th Nov (38 days). He received a premium of $7.40/share or $740/contract. He has essentially executed a covered call strategy.

poor man's covered called (options strike 1)

Now, if the share price of FB remains below $300/share when the contract expires on 20th Nov, this call option contract which the investor sells will become “worthless”. He continues to own 100 shares of FB and his cost price has effectively been reduced from $275/share to ($275-$7.40) $267.60/share.

He can then repeat the “covered call” selling process and sell another options contract over the next month with expiration in December and generate another round of premium which will go towards further reducing his cost price.

This is where the passive income potential comes in. Done properly, the investor can consistently generate income by selling covered calls consistently every month.

However, if FB price exceeds $300/share when the option contract expires on 20th Nov, that is where his “obligation” sets in. He is now obligated to sell 100 FB shares at the price of $300/share.

Since he already owns 100 shares of FB at a cost of $267.60/share (plus the premium received from selling the call option), his total profit from this trade will be $300-$267.60 = $32.40/share or $3,240 in total. This is a total return on capital of c.12% over one month. Not too shabby.

Note that this “covered call” option strategy is a low-risk strategy. The main “risk” is the opportunity cost of not being able to partake on the upside if FB price appreciates significantly above $300/share as the investor’s profit is now “capped” at $300/share.

However, what if one doesn’t have $27,500 of capital to own 100 shares of FB in the first place? Can one still get to execute this income strategy?

This is where the poor man’s covered call strategy comes into play.

Poor man’s covered call strategy    

The key differentiating point between the poor man’s covered call strategy vs. the traditional covered call strategy is that the former does not entail the purchase of (at least) 100 shares of the stock.

The poor man’s covered call strategy involves the PURCHASE of 1 call option and the SALE of 1 call option. This strategy is similar to an option Vertical/spread. However, the difference is that both options have different EXPIRATION dates.

A poor man’s covered call strategy also has unique characteristics vs. an option Vertical beyond just the expiration criteria.

First, the BUY leg of the call option will generally entail a Deep-ITM option, one which typically has a Delta of at least 0.80 or higher. An option that has a delta of 1.0 essentially replicates the price movement of the underlying exactly, ie: if FB price moves from $275 to $280 or a $5 movement, the price of the option will also move by $5.

If the option has a delta of 0.80, that means a $5 underlying FB price movement will translate to an option price movement of 0.80*$5 = $4.

What we want to purchase is an option that essentially “fully mimics” the price movement of the underlying shares. So instead of owning the shares outright, we can essentially own an option contract at a fraction of the cost of the shares (100 shares at least).

poor man's covered called (options strike 2)

Take the above FB option chain with a contract expiry of 465 days. The Strike 200 has a delta of 0.82 (considered deep-ITM) and that particular option cost approx. $94.80/share or $9,480/contract to own. Compare to owning 100 shares of FB at a total cost of $27,500, that is almost a 60% cost reduction while yet still essentially “own” 100 shares of FB.

For this particular option which has a delta of 0.82, if FB price moves from $275 to $280 or a $5 movement (ROI of 1.8%), the option price will move by approx. 0.82 * $5 = $4.10 from $94.80 to $98.90 or a return on capital of 4%.

Second, the buy leg of the option, besides being deep ITM, typically also entails one that has a long expiration. In the above example, the expiration period is 465 days which is considered relatively long. FB has long-dated options available to Jan 2023.

For a similar strike of $200, the one with an expiration of 829 days cost $10,655 vs. the above example with an expiration of 465, the option cost $9,480. The difference of $1,175 is the additional time value cost for owning the contract with a longer duration.

Third, for the SELL leg of the call option, it typically consists of a “short-dated” contract (30 days, etc). The reason why the sell leg of the call option is one that has a short DTE is to take advantage of Theta or Time Value Decay.

Theta decays happen the fastest in the last month (left with 30 days) of the option contract, that is why as the Seller of the contract, one will benefit the most from the rapid theta decay of the option contract since the investor has already “pocketed” the premium and will want this number to hit ZERO as fast as possible (Sell high and buy back low).

Fourth, the SELL Leg of the call option typically consists of one that is Out-of-the-money (OTM), ie, the strike price is above the current underlying share price of $275. For the BUY leg, who knows that one should select a strike price with a Delta value of at least 0.80 or higher. For the SELL leg, which is the right strike price to sell?

There is honestly no “right” strike price. If one has a targeted “fair value” for FB in mind, that might be the level at which the investor can structure the Sell Leg. For example, if an investor believes that $300 is the fair value of FB, then he/she can structure a Sell leg with a strike price of $300.

In our example above, selling an option with a strike of $300 generates a premium of $740/contract with a contract duration of 38 days.

Alternatively, one can also look at the chart and based the Sell strike on the resistant level of the stock.

poor man's covered called (FB chart)

For FB, the resistance is also coincidentally at the $300 level, hence, an investor who based the structuring the Sell strike based on technical factors might also look to sell the option with a strike price of $300.

I usually structure the Sell Strike based on a Delta of 0.30. This also corresponds to a 1 Standard Deviation (SD) level.

Again, for FB, with a contract expiration of 38 days, the call option with a delta closest to 0.30 corresponds to a Strike price of $300.

poor man's covered called (options strike 3)

FB poor man’s covered call

So assuming if I wish to structure a poor man’s call option for FB, I could purchase the Strike 200 Call Option that expires in 465 days-time, costing me $9,450 while concurrently selling the Strike 300 Call Option that expires in 38 days-time, generating me an income of $740.

If FB price stays below $300 on the expiration date in 38 days-time, I get to pocket the full amount of $740. In this case, my “yield on cost” is 740/9,450 = 7.8% over 1 month. I can then repeat the same process of selling the poor man’s covered call the following month.

Assuming I can repeat this process for 12X (approx. 1-year), I will be able to almost fully (95%) recoup my cost of the Long Call option. This means I have “free” exposure to 100 shares of FB through the 1 Long Call contract (with a strike of $200).

Compared to the traditional covered call strategy which entails a capital of $27,500, the yield on cost will be relatively lower at 740/27,500 = 2.7%/month.

What happens if FB price is above the Sell Call strike on expiration?

Recall that for the covered call strategy, if the price of the counter appreciates beyond the SELL strike, as the seller of the call option, the investor will be obligated to sell his 100 shares of FB at the Sell Strike price (ie, $300 in this example). Since he already owns 100 shares of FB, his net exposure will be ZERO remaining FB shares but a total profit of $3,000+.

For the poor man’s covered call, because the investor does not “directly” owns 100 shares of FB but having an indirect exposure through the 1 long DTE (465 days) Call option contract, if the price of FB exceeds the Sell Strike of $300 on the short call expiration (38 days), he/she will be forced to “sell short” the shares of FB at a strike of $300.

This means that his final exposure will be: +1 Long Call FB contract and -100 FB shares

In this scenario, it will be appropriate for him to close off both his long call option and negative shares together and book his profit.

Assuming FB price closes at $305 on 20 Nov. His “Short Stock” position will incur a loss of ($305-$300)*100 = $500 (losses)

His Long Call Options contract, which he originally purchased at $9,450 (Intrinsic value of $7,850, time value of $1,600) will now be worth around $12,000 (Intrinsic value of $10,500 (($305-$200)*100 shares), time value of $1,500) which he can sell in the open market.

Note that he does not need to “exercise” this call option to purchase 100 shares of FB at a cost of $200 (strike price). If he does that, he will essentially be foregoing his $1,500 time value.  

His profit from his Call option is $12,000 – $9,450 = $2,550

So his total net profit = $2,550 (long call option) – $500 (short stock) + $740 (premium from selling the call option) = $2,790

On an initial capital of $9,450, that represents an ROI of 39.5% over a horizon of just 38 days. On an annualized basis, that is an ROI of 284%.

Conclusion

The covered call strategy is a low-risk option strategy to generate income consistently. This strategy involves buying (at least) 100 shares of a stock and selling a short DTE call option contract on the underlying.

The poor man’s covered call strategy is similar. However, instead of owning 100 shares of the stock, one will just purchase a deep ITM option (delta at least 0.80) which has a substantially lower cost (60-70% lower) vs. buying the shares directly. Similarly, one will sell a short DTE call option contract.

Personally, when structuring the Sell Leg of the call option, I will tend to choose a strike with a delta of 0.30 which corresponds to approx. 1 SD. However, there is no one single “right” strike to sell the call option at.

Not all stocks should be executed with a poor man’s covered call strategy or at least my preferred choice in choosing the type of stocks are those that are generally more stable (beta at 1 or below) or less volatile. This lowers the likelihood of the price spiking above the Sell Call strike which will allow me to continuously sell call options in the forward months.

For high dividend stocks, do note the following. As a Call Option Holder, you are NOT a shareholder of the company and will not be entitled to any dividends declared. When a dividend goes ex-dividend, it will “typically” benefit the Sell Leg of the Call (although this is generally already priced into the option value).

Do check out this strategy if you are considering purchasing at least 100 shares of a counter in the first place.      

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Disclosure: The accuracy of the material found in this article cannot be guaranteed. Past performance is not an assurance of future results. This article is not to be construed as a recommendation to Buy or Sell any shares or derivative products and is solely for reference only. 

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