Archimedes was considered one of the greatest mathematicians and scientists of ancient antiquity. Although it’s a common misperception that he invented the lever, he definitely understood its power. He famously stated, “give me a place to stand on, and I will move the Earth.” Leverage in finance is defined as using borrowed capital to boost returns. However, leverage is generally defined as small focused actions that can produce outsize results. The Poor Man’s Covered Call is an options strategy that can produce leverage by allowing you to control a significant amount of an underlying security for a fraction of the cost of purchasing the shares outright. The leverage inherent in the strategy makes it highly profitable without a significant increase in the risk. As a result, investors should familiarize themselves with the strategy and use it in their portfolios.
What Is a Poor Man’s Covered Call
The Poor Man’s Covered Call is a poorly understood and a poorly named options strategy. If anything, by using this strategy you have the potential of generating outsized returns. A Poor Man’s Covered Call (PMCC) is essentially a synthetic covered call that can be entered into without owning the underlying shares. In a traditional covered call position, you must first purchase one hundred shares of the underlying security. The second step is to sell a short dated call. If the share price at the time of expiration is above the strike price of the short call, the buyer will exercise the call option. Thus, he will buy the shares from you (the writer) at the specified strike price. Fortunately, since you already own the shares you will simply deliver the shares already held within your account. A covered call means your position is covered by already owning the shares as opposed to naked, which means you don’t own the underlying shares. Needless to say, naked cover call writing can theoretically generate unlimited losses and I would never recommend entering such a speculative trade. Furthermore, most brokerage companies will not allow you to sell naked calls. With a Poor Man’s Covered Call you purchase a long dated LEAPS option as the underlying security instead of 100 shares of stock. Normally, you purchase an in-the-money long dated call option and then sell a near-term short-dated call option that is out-of-the-money. Essentially, you’re selling the short call to reduce your cost basis on the LEAPS that you own. A PMCC position is considered bullish since you maximize your profit when the shares trade above the strike of your LEAPS option.
Why Should I Use a Poor Man’s Covered Call Strategy?
At Ashva Capital, we view covered call writing as an integral portion of our investment strategy. It’s a conservative strategy that can even be utilized in retirement accounts. However, the PMCC is superior to traditional covered call writing in regard to the use of capital. In order to enter into a covered call position you must own at least 100 shares of the underlying stock. For example, if you wanted to right a covered call on Amazon you would need at least $337,000 to simply purchase 100 shares at current market prices as Friday (04/23/2021). For the vast majority of investors, this transaction wouldn’t be feasible because of a lack of capital. Even if an investor had a $1 mn retirement portfolio, it wouldn’t be prudent to tie up approximately 34% of his capital in a single position. However, an investor could enter into a PMCC position by purchasing the January 20, 2023 LEAPS at a 2,600 strike price for $97,830. Essentially, we can enter into a synthetic long position for 71% less capital. For virtually all individual investors using a PMCC strategy will allow them to maintain proper diversification in their portfolio in comparison to a traditional covered call strategy. Additionally, your maximum loss is limited to the premium that you pay less any premium earned from selling short calls.
An Example of a Poor Man’s Covered Call Strategy
Going back to the Amazon example, if we purchased the January 20, 2023 LEAPS at a strike price of 2,600 we would pay $97,380. I chose this particular LEAPS contract because it had a delta of 0.8. Delta measures by how much the price of an option will change based on a price change in the underlying security. In our example, a delta of 0.80 means that for every $1.00 increase in Amazon’s share price our option will increase by $0.80. After purchasing the LEAPS option, we want to sell a near-term call to generate premium income. Our goal is to sell as much premium as possible until we either close out the LEAPS position or roll it over to an expiration date further in the future.
In our example, if we sold the May 21, 2021 calls options with a strike price of 3525 we would receive a premium of approximately $5,200. At the time I’m writing this article, there are still 28 days till expiration. Thus, we would generate a total return of 6% in a 28 day period. Assuming, we could write premium between 8-10 times a year our total return would be in the range of 48% to 60% annualized. Clearly, this strategy isn’t named correctly because anyone generating those types of returns won’t be a poor man for very long. Additionally, I’ve only factored in the income generated via selling premium. There will also be a component of capital appreciation in the underlying LEAPS contract if the share price continues to increase over time.
I know what you’re thinking, there has to be some downside. Obviously, no option strategy is fool-proof. There are some significant downside risks. First, in the instance the shares trade significantly above the short call strike price you will be forced to either buyback the short call at a significant premium or purchase the shares. Unlike a covered call position, we don’t want the short call position to be exercised if it’s trading in-the-money. If our short call was in-the-money at its expiration date the profit we would generate would be equal to the width of the call strikes – net debit paid. In our example, the width of the call strikes is $925 and the net debit outlay was $926.3. Thus, we would lose approximately $1.3 per share if the share price rose above the short call strike price. The ideal scenario would be for the share price to trade below the strike of the short call upon expiration, which would then give use the ability to continue writing premium.
Your goal with the PMCC position is to continually sell premium for as long as you own the underlying LEAPS position. Remember, we can generate up to 48% to 60% over the course of a year on our initial capital outlay if we continue to sell premium.In our example, the January 20, 2023 LEAPS have 1.75 years until maturity. I would buy the LEAPS two years out so that theta decay doesn’t materially reduce the value of our position while we’re generating premium income. Theta refers to the rate of decline in the value of an option as time passes. We must always remember that LEAPS options have a finite life. Theta decay usually sets in when an option has less than one year to maturity. By buying a LEAPs contract with 1.75 years to maturity we ensure that the underlying value of our long LEAPS position is driven primarily by changes in the share price of the underlying stock and not time decay. A PMCC strategy is not for everyone and must only be used on stocks that you’re willing to hold longer term.
The outsize returns generated via a PMCC is due primarily to the inherent leverage. By purchasing a single LEAPS contract of an underlying stock, you’re able to control essentially 100 shares for a fraction of the cost of acquiring them outright. As Archimedes had the power to move the world, you can utilize the PMCC strategy in your portfolio to achieve levered returns. Any investor can utilize this strategy to enhance their portfolio returns without significantly more risk than following a covered call option writing strategy.
