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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.
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.
How I Approach a 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 General Electric (NYSE: GE).
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 GE stock.
If we were to buy GE stock at $25.19 per share, our capital requirement would be a minimum of $2,519 plus commissions ($25.19 times 100 shares).
If we look at GE’s option chain, we will quickly notice that the expiration cycle with the longest duration is the January 2017 cycle, which has roughly 476 days left until expiration.
With the stock trading at $25.19, I prefer to buy a contract that is in the money at least 10%, if not more. Let’s use the $18 strike for our example.
We can buy one options contract, which is equivalent to 100 shares of GE stock, for roughly $7.20, if not cheaper. Remember, always use a limit order – never buy at the ask price, which in this case is $7.60.
If we buy the $18 strike for $7.20 we are out $720, rather than the $2,519 we would spend for 100 shares of GE. That’s a savings on capital required of 71.4%. Now we have the ability to use the capital saved ($1,779) to work in other ways.
The next step is to sell an out-of-the-money call against our LEAPS contract.
It seems as though the only call strike worth selling in GE is the November $26 strike with 49 days left until expiration. If we chose a stock with a slightly higher price we could go out two, three, four or more strikes away from the current price of the stock. But, I want to use a very conservative example so we understand the basic risk/reward.
So, let’s say we decide to sell the $26 strike for $0.46, or $46, against our $18 LEAPS contract.
Our total outlay or risk now stands at $674 ($720 LEAPS contract minus $46 call).
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.
To learn more about poor man’s covered calls – and other income-producing options strategies – I invite you to check out my High Yield Trader service. If you’re interested, just click here for more details.