As many of you know, I am a contrarian at heart. Almost every decision I make as an investor is based on a contrarian way of thinking. So, when I see that a commodity necessary for societies around the world to function is off 80% and at historic lows, I begin to search for the best way to take advantage of the opportunity.
I’ve discussed selling puts in the United States Oil Fund (NYSEArca: USO) as a way to enter into a position in oil numerous times over the past six months. I decided to piggyback on last week’s webinar by discussing poor man’s covered calls.
I discussed, in great detail, how I use poor man’s covered calls in my latest webinar. If you are interested in any of the strategies mentioned above, take a look at my most recent webinar for a detailed account of how I approach the strategy in my High Yield Trader service.
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 stock or ETF that I am comfortable owning for the long term. This is a crucial first step.
Take for instance the United States Oil Fund.
The ETF exemplifies the typical scenario 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 USO.
If we were to buy USO shares at $10.16 per share, our capital requirement would be a minimum of $1,016 plus commissions ($10.16 times 100 shares).
If we look at USO’s option chain, we will quickly notice that the expiration cycle with the longest duration is the January 2018 cycle, which has roughly 504 days left until expiration.
With the stock trading at $10.16, I prefer to buy a contract that is in the money at least 10%, if not more. Let’s use the $8 strike for our example.
Yes, I’m talking about oil. I know, I know, some “professional” analysts are calling for a move to $10 a barrel, but I’m not willing to lose out on an investment opportunity by trying to frivolously call a bottom.
Contrarians often look like dummies in the beginning. But with oil, it’s about the long term. As an investor, what I don’t want to risk is potentially losing out on an opportunity to invest in a crucial resource at an 80% discount just to avoid the possibility of looking foolish. As an investor, I couldn’t care less about the opinions of others. I simply focus on my own research and attempt to take calculated risks that will put me in the best position to succeed.
We can buy one options contract, which is equivalent to 100 shares of USO, for roughly $3.00, if not cheaper. Remember, always use a limit order – never buy at the ask price, which in this case is $3.05.
If we buy the $8 strike for $3 we are out $300, rather than the $1,016 we would spend for 100 shares of USO. That’s a savings on capital required of 70.5%. Now we have the ability to use the capital saved ($716) 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 USO is the October 10.5 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 10.5 strike for $0.38, or $38, against our LEAPS contract.
Our total outlay or risk now stands at $262 ($300 LEAPS contract minus $38 call). At first, the premium seems small, but on a percentage basis selling the 10.5 call premium for $38 reaps a return on capital of 12.7% over 49 days. Of course, your upside is limited to $10.50 with this trade. But hey, is it so bad to lose out on some potential upside to make a 12.7% gain over 49 days?
An alternative way, if you wish to participate on a continued upside move in USO, is to buy two leaps in the ETF and only sell one call against it. This will increase your deltas and allow half of your position to participate in a move past $10.50.
No matter the approach, 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.
I hope this helps give you all some additional food for thought regarding the power of options. Again, if you would like to learn more about the strategies, make sure you check out my latest webinar, where I talk about the strategies I use in my High Yield Trader service, plus share a five real-time trading examples to help shorten the learning curve.