Poor Man's Covered Call vs. Traditional Covered Call

Poor Man’s Covered Call vs. Traditional Covered Call


Interested in selling covered calls, but can’t fork-up the cash required? You’re in the right place. By the end of this article, you’ll know how to sell calls and collect options premium on a budget without exposing yourself to undefined risk!

Intro to covered calls

Covered calls provide a great introduction to using options. They get traders and investors acquainted with must-know concepts like hedging, collecting premium, time decay and more.

How to use covered calls

Step 1. You buy or own 100 shares of stock.

Step 2. You sell a call option against those shares at a share price you’re willing to sell at. This is an agreement to sell your 100 shares at a particular price (your strike price), at a particular date (your expiration date). In exchange for making this agreement, you collect a premium — that’s the price of the option you sold.

Step 3. If, on the expiration date you selected, the stock is trading higher than the strike price you selected, you complete your end of the deal: selling the 100 shares at the strike price you provided to the buyer of the option you sold. If the stock isn’t trading higher than the strike price on the expiration date, nothing happens. The option you sold expires worthless, you keep the premium you collected upfront, you keep your shares, and you can sell another call against them if you wish.

Why beginners and pros alike use covered calls

The simple answer for why so many people love covered calls is that they’re a relatively low-risk strategy. The premium collected by covered calls can lower the cost-basis of your shares, provide a small hedge against downside price action, and allow you to take advantage of an option’s time decay without a ton of work.

Of course, one con to using the strategy is that you’re capping your maximum upside potential. If the stock flies well above your strike price, you might miss out on some of those gains. But for mildly bullish investors and traders, the covered call can be a powerful and useful tool.

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The problem with covered calls

100 shares of a stock can be very pricey, especially for someone who’s just starting out. For instance, 100 shares of Apple (AAPL) at its current price would cost a trader roughly $14,200. Of course, selling an upside call will lower the cost-basis a bit, but probably only by $100-$300 dollars (Though that figure will depend heavily on the expiration and strike you select — it could be much more, or much less depending on the risk you’re willing to take on.)

For investors who want to sell “covered calls”, but don’t quite have the capital (or aren’t willing to risk that amount of capital), we have good news: there’s another way.

The “Poor Man’s Covered Call”

We put “Poor Man’s Covered Call” in quotes because that’s just a nickname — technically, this strategy is actually called a diagonal spread. Rather than buying 100 shares of a stock, the “Poor Man’s Covered Call” utilizes a longer-dated call option, which will always be cheaper than 100 shares of the same stock.

How to use a “Poor Man’s Covered Call”

As the name suggests, using the “PMCC” is quite similar to the covered call. It goes like this:

Step 1. You buy or own a call option in a stock — usually an in-the-money option with plenty of time left before the expiration date.

Step 2. You sell a shorter-dated call option above the strike price of your longer-dated call option — usually an out-of-the-money option with a short amount of time left before the expiration date. (At Market Rebellion, we often target options that are roughly 2-weeks away from expiration. This is when the time decay really starts to ramp up.)

Step 3. If on the expiration date you selected the stock is trading higher than the strike price of your short option, your long option will act as 100 shares of the stock at a price equivalent to the strike. Your long option is sold, and your profit is equal to the difference between the two strikes, minus the debit you paid to enter the position. If, on the other hand, the stock is not trading higher than the short strike price on the expiration date of the short leg, the option expires worthless and you collect the upfront premium and keep your long option, allowing you to sell another call against it if you wish.

The difference between a “Poor Man’s Covered Call” and a covered call

There are a few key differences between these strategies. A “PMCC” has more sensitivity to price moves in the underlying stock, because options are leveraged instruments — so on a percentage basis, your position may gain or lose value at a greater rate than if you were simply holding shares.

Also, options decay. Your short option will decay at a greater rate than your long option, offsetting some of the decay, but overall this is still a “theta-negative” position, meaning that time decay has a negative effect on the overall value. Comparably, covered calls that use shares are “theta-positive” — your only option is a short position, and shares do not decay.

Additionally, there’s a difference in the way volatility affects these two strategies. Traditional covered calls only contain one type of option — short. Short calls are negative vega. That means they benefit from declining volatility. On the other hand, a “PMCC” contains two calls — one short, and one long. This is a positive vega strategy, meaning that it benefits from a rise in volatility. Being positive vega means if volatility surges, your long-option will be a greater beneficiary than your short option, ultimately raising the value of your “Poor Man’s Covered Call”.

However, the biggest and most important difference is in the price associated with entering the position.

The difference in cost between a “Poor Man’s Covered Call” and a covered call

The “Poor Man’s Covered Call” will not only be cheaper, but also offers wider variability. For instance, recall the Apple example from above. To purchase 100 shares at the current price ($142) would cost roughly $14,200. Imagine that you sold a $146-strike call against it (this is at the 30-delta, a common target for selling covered calls), expiring in about two weeks (July 8th, in this case). Using the current real-life option chain, we see that the premium associated with that option is $1.50. That means we could trim $1.50 per share off of our $142 cost basis — meaning entering this covered call trade would cost a grand total of $14,050.

Let’s compare that to a few different options we could use to enter a “Poor Man’s Covered Call”

You could take a LEAPS-based approach, selling that same two-week-out, $146-strike call for $1.50, and buying an in-the-money call expiring more than a year away (in this case, expiring September of 2023), at the $140-strike. Using the real-life options chain, we can see that this long $140-strike call would cost the user roughly $23.10. That means our overall cost basis to enter this position would be $21.60 ($2,160). We’re risking less than 20% of what we would have had to risk on a traditional covered call play in order to make this trade, and by selecting an expiration more than a year away, our position will be highly resistant to time decay in the short-term.

But if you wanted to risk even less to take the position, the “Poor Man’s Covered Call” has got you covered. You could opt to use the same strike ($140), two months out (August of 2022). In this case, that would cost you $8.50. With the cost of the short option at $1.50, the total price you pay to enter this shorter-dated “PMCC” is just $7.00 ($700) — roughly 5% of the premium you would have paid in the traditional covered call example above.

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Tips and tricks: perfecting the “Poor Man’s Covered Call”

Selling options and collecting premium is a great strategy — but with a little nuance, you can take it to the next level. Here are three brief tips that can help you do that.

  • If you have a very bullish opinion, this is the wrong strategy

If you expect the stock in question to rip higher, you’re better off not opening the short leg until after the stock completes the move you’re expecting.

  • Be mindful of volatility

Volatility adds “extrinsic value” to options. That’s a fancy way of saying they cost more in periods of high volatility, and less in periods of low volatility. As we covered above, volatility has a different effect on covered calls than it does on the “Poor Man’s Covered Call”.

That means if you have a positive directional opinion on the volatility of the underlying stock, the “PMCC” is likely a better strategy. Contrarily, if you think the volatility is about to decline, you might be better off using a traditional covered call.

  • You don’t have to hold your short call to the expiration date

While it can be tempting to squeeze every cent of premium out of an option that you’re sure is going your way, resist the temptation. If your short option has decayed to the point where you’ve already collected the majority of the premium associated, it’s best practice to close it. For instance, if you sold the Apple call referenced above for $1.50, and now, with two days to the expiration date, it’s worth just $0.15, is it really worth holding on for two more days just to get that measly $15? We don’t think so.

Instead, if you still want to be in the trade, you could roll the option to a new strike price or expiration date — to an option with more premium to collect. At least that way, there’s a reasonable risk/reward profile. Alternatively, you could take profit on the short call by “buying to close” the position, and wait for another more suitable opportunity.

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