One of the most popular income strategies among all investors is, hands down, the covered call strategy. Buy a stock, sell call options against it. By selling call options against your shares of stock you can lower the cost basis of your stock or simply use the call premium from selling the options as a source of income.
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.
But, there is an alternative to a covered call strategy . . . a good one. It’s a strategy known among options geeks as the “poor man’s covered call.”
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. Essentially, LEAPS, when used in a poor man’s covered call strategy, act as a stock alternative.
The Poor Man’s Covered Call: Mechanics
So how do I start in the poor man’s covered call?
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, Wal-Mart Stores (NYSE: WMT).
The stock exemplifies the typical low-beta, blue-chip stock that I look for when using a poor man’s covered call strategy.
The next step is to choose an appropriate LEAPS contract to replace buying 100 shares of WMT stock.
If we were to buy WMT stock at $99.18 per share, our capital requirement would be a minimum of $9,918 plus commissions ($99.18 times 100 shares).
If we look at WMT’s option chain, we will quickly notice that the expiration cycle with the longest duration is the January 2020 cycle, which has roughly 751 days left until expiration.
With the stock trading at $91.18, I prefer to buy a contract that has a delta of around .80. Let’s use the $75 strike for our example.
We can buy one options contract, which is equivalent to 100 shares of WMT stock, for roughly $27.20. Remember, always use a limit order – never buy at the ask price, which in this case is $28.85.
If we buy the January 2020 $75 strike for $27.20, we are out $2,720, rather than the $9,188 we would spend for 100 shares of WMT. That’s a savings on capital of 70.4%. Now we have the ability to use the $6,468 in capital saved to work in other ways.
The next step is to sell an out-of-the-money call against our Jan 2020 75 call LEAPS contract.
We can sell the February $100 strike with 51 days left until expiration against our WMT January 2020 LEAPS.
So, let’s say we decide to sell the $100 strike for $2.36, or $236, against our $100 LEAPS contract.
Our total outlay or risk now stands at $2,484 (cost of January 2020 LEAPS contract minus premium of February $100 call) and our return on the trade over 51 days is 8.7% for the poor man’s covered call.
Using the poor man’s covered call strategy, 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.