Most of us have used ̶ or at least heard about ̶ covered calls.
Buy a stock, sell calls against it.
It’s an easy strategy to implement, but the problem, at least for some, comes down to capital. You must have at least 100 shares of stock to sell a call. For some, acquiring 100 shares just isn’t affordable. Others prefer not to up tie up working capital toward 100 or more shares of stock.
There is an alternative to a covered call strategy. And it’s a good one. In the options world the strategy is referred to as poor man’s covered call.
How the Strategy Works
A poor man’s covered call is similar to a traditional covered call strategy, with one exception in the mechanics. Rather than buying 100 or more shares of stock, an investor simply buys an in-the-money LEAPS call and sells a near-term out-of-the-money call against it.
LEAPS, or long-term equity anticipation securities, are basically options contracts with an expiration date longer than one year. LEAPS are no different than short-term options, but the longer duration offered through a LEAPS contract gives an investor the opportunity for long-term exposure.
Other than reducing the capital required, the reason we purchase LEAPS is to minimize the extrinsic value and theta decay. Basically, a poor man’s covered call is viewed as a diagonal trade with a significantly longer duration.
First of all, I always start – just like when I use a traditional covered call strategy – by choosing a low-beta stock. I want a stock with low volatility because the strategy works best when there is minimal vacillation in the underlying stock.
Take, for instance, Altria (NYSE: MO). The stock has experienced a recent pullback, which could offer a nice entry point for a poor man’s covered call.
The next step is to choose an appropriate LEAPS contract to replace buying 100 shares of MO stock.
If we were to buy MO stock at $63.82 per share, our capital requirement would be a minimum of $6,382 plus commissions ($6,382 times 100 shares).
If we look at MO’s option chain, we will quickly notice that the expiration cycle with the longest duration is the January 2019 cycle, which has roughly 476 days left until expiration.
We can buy one options contract, which is equivalent to 100 shares of MO stock, for roughly $12.70, if not cheaper. Remember, always use a limit order – never buy at the ask price, which in this case is $13.
If we buy the $52.50 strike for $12.70 we are out $1,270, rather than the $6,382 we would spend for 100 shares of MO. That’s a savings on capital required of 80.1%. Now we have the ability to use the capital saved ($5,112) to work in other ways.
The next step is to sell an out-of-the-money call against our LEAPS contract.
So, let’s say we decide to sell the $65 strike for $1.22, or $122, against our $52.50 LEAPS contract.
Our total outlay or risk now stands at $1,148 ($52.5 LEAPS contract minus the premium of the 65 call).
Our premium return on the trade is 9.6% over the 49 days.
We can continue to sell calls against our LEAPS contract every month or so to lower the total capital outlay. But remember, options have a limited life, so when we get closer to the LEAPS contract’s expiration we will simply sell the contract and use the proceeds to continue our poor man’s covered call strategy.