A covered call is an options strategy where an investor holds a long position in an asset and writes (sells) call options on that same asset to generate income from premiums received. The covered call caps upside potential in exchange for the premium earned. A “poor man’s covered call” aims to simulate a covered call but without purchasing the underlying asset. Instead, the investor buys long-term in-the-money call options paired with writing short-term out-of-the-money call options above the long call strike. This article will examine how poor man’s covered calls work, strategies to utilize them, and tips for profiting from this technique.
A poor man’s covered call, also known as a “synthetic covered call”, uses deep in-the-money LEAPs (long-term equity anticipation securities) instead of the underlying shares to mimic covered call payoff. LEAP call options typically expire in 1-3 years.
Here are the steps when implementing a poor man’s covered call:
- Buy an in-the-money LEAP call option on the underlying stock
- Sell shorter-term out-of-the-money call options each month against the LEAP
The purchased LEAP acts as a substitute for owning the stock since it moves dollar-for-dollar with the underlying price. Selling monthly calls generates income like a standard covered call. However, the cost is significantly lower compared to buying 100 shares per call contract. This defines an affordable “synthetic” covered call.
When entering a poor man’s covered call, choose LEAPs with >0.80 delta to closely track the underlying stock price. Also select an expiration date 1-2 years in the future.
For the short calls sold against the LEAP, target around 30-60 days until expiration with strikes OTM enough to create income. Roll these short calls at or before expiration.
Ideally, the underlying stock trades sideways or rises slowly for maximum profit. Aggressive drops in the stock price can result in losses similar to owning the stock itself.
- Buy 1 LEAP $50 call for $8.00, Sell 1 short $55 call for $1.00
The $8.00 LEAP premium spent functions like owning 100 shares of stock at $50. Writing the $55 short call creates $1.00 income just like a covered call. If assigned on the $55 call before expiration, the LEAP call option offsets the 100 shares called away at $55.
- Buy 1 LEAP $30 call for $10.50, Sell 1 short $35 call for $2.00
The $10.50 LEAP premium is lower than buying 100 shares at the $30 strike. The $2.00 short call premium generates income against the LEAP. If the $35 call is assigned early, the LEAP call is exercised to deliver 100 shares at $30, covering the obligation.
Strategies Using Poor Man’s Covered Calls
There are a few strategic approaches when deploying poor man’s covered calls:
The primary motivation is consistent income from short call premiums. Choose stocks that pay solid dividends and utilize poor man’s covered calls to create an income stream. Roll the short calls at expiration.
With the long LEAP in place, gains in the stock are amplified compared to owning the stock outright. If the price surges, the LEAP acts as leveraged participation in the upside.
This approach minimizes the capital required compared to standard covered calls. The LEAP call premium costs much less than 100 shares, enabling trading with less cash.
To avoid assignment around earnings, either buy back the short calls early or delay selling new calls until after the announcement. The LEAP provides stock exposure through earnings.
There are several ways to generate profits from poor man’s covered calls:
- Income from Short Call Premiums – The primary source of gains is the monthly income accumulated from repeatedly selling short-term out-of-the-money calls against the long LEAP call.
- LEAP Gains if Stock Rises – If the underlying stock price appreciates significantly, the increase in the LEAP call value produces leveraged gains compared to stock ownership.
- LEAP Gains on Time Decay – As the LEAP call moves closer to expiration, the erosion of time value also contributes to profits.
- Profit from Favorable Price Action – If the stock rises slowly or trades sideways under the short call strikes at expiration, the strategy generates income without the LEAP or shares getting called away.
- Roll for Additional Credit – As short calls expire, continuing to roll the calls out in time and up in strike to capture additional premiums will increase income.
Here are some useful tips for effectively trading poor man’s covered calls:
- Stagger the short call expirations to create a ladder generating periodic income
- Actively manage the trade when the stock approaches short call strikes before expiration
- Consider using margined LEAPs to lower capital requirements and increase potential returns
- To limit risk, purchase protective puts or collars if the underlying sells off significantly
- Be prepared to exercise the LEAP if assigned early on a short call to obtain shares
- Avoid overpriced LEAPs – look for quality LEAPs trading at fair value or discount to maximize profits
- Research upcoming dividends which may affect short call pricing when selling calls
The poor man’s covered call provides an efficient means of generating income from options premiums with limited capital. By purchasing affordable long-term LEAP call options and pairing short-term call sales against them, retail traders can simulate covered call returns. Careful management of the short calls, timely rolling, and monitoring for early exercise enables consistent profits from this synthetic strategy. With the right underlying stock selection and disciplined execution, the poor man’s covered call can produce steady income for an individual investor’s portfolio.