Let’s consider the world of investing. It’s vast, complex, and can often feel like a labyrinth that’s difficult to navigate. From stocks and bonds to futures and options, the array of investment choices can be overwhelming, especially when you dive into the more advanced strategies. Today, we’re zooming in on one such technique that, while sounding a tad ironic, can offer considerable benefits. Enter the realm of the poor man’s covered call.
Demystifying the Poor Man’s Covered Call
Imagine you’re eyeing a high-priced stock, say, for instance, Amazon, but you just don’t have the capital to buy 100 shares. This is where a poor man’s covered call comes in handy.
In essence, the poor man’s covered call is a less capital-intensive version of a traditional covered call. Instead of owning the underlying stock, you own a LEAPS (Long-term Equity Anticipation Securities) option. These are options contracts with expiration dates typically more than a year away. The advantage? They mimic stock ownership at a fraction of the cost, making this strategy more accessible to individuals with smaller portfolios.
A Step-by-step Walkthrough
Let’s break it down further with an example. Assume Amazon’s stock is currently trading at $3,000 per share.
- Buy a LEAPS call option: You purchase a LEAPS call with a strike price of $2,500 that expires in two years. Let’s say this costs you $600 per share. The out-of-pocket expense is $60,000 ($600 x 100 shares) compared to the $300,000 you would have spent on buying the stock outright.
- Sell a short-term call option: You then sell a call option with a strike price of $3,100 that expires in one month, and you receive a premium of $15 per share. The collected premium is $1,500 ($15 x 100 shares).
This process creates a ‘spread.’ Your potential profit is the difference between the strike prices of the long LEAPS option and the short call option, minus the net cost of entering the position.
The Beauty of the Poor Man’s Covered Call
The strategy is attractive for several reasons.
- Lower capital requirement: As illustrated in the example, it requires significantly less capital than a standard covered call.
- Generates income: It’s an excellent method to earn a steady income from the premium collected from the sold call option.
- Risk Control: If the stock price plummets, your maximum risk is the premium paid for the LEAPS option, not the full cost of owning the stock.
But, be warned. This strategy isn’t risk-free. If the stock price rises too quickly, the short call option could get exercised, capping your profits.
Anecdote: A Tale of Two Investors
Consider two investors, Investor A, who uses a traditional covered call strategy, and Investor B, who deploys the poor man’s covered call.
Both investors are interested in Amazon’s stock trading at $3,000. Investor A buys 100 shares, costing $300,000, and sells a call option for $1,500. Meanwhile, Investor B uses the poor man’s covered call. He buys a LEAPS option for $60,000 and sells a call option for $1,500.
If Amazon’s stock price falls drastically, Investor A stands to lose a substantial amount compared to Investor B. While Investor B could lose $60,000 at most, Investor A’s losses can be much more significant. This anecdote underlines the appeal of a poor man’s covered call for risk-averse investors.
In the complex world of investing, the poor man’s covered call strategy stands out for its accessibility and risk management. Though it’s not without risks, with careful planning and management, it can turn out to be a highly profitable approach. Whether you’re a poor man dreaming of riches or a rich man looking for savvy investment strategies, this technique could be an attractive addition to your investing toolkit. The poor man’s covered call could turn out to be a not-so-poor strategy after all!
Frequently Asked Questions (FAQs)
What is a poor man’s covered call example?
A poor man’s covered call example might be like this: Assume Apple’s stock is currently trading at $150 per share. You would first buy a LEAPS call option with a strike price of $130 that expires in two years. You then sell a short-term call option with a strike price of $155 that expires in one month. The goal here is to collect premium income from selling the short-term calls while having the LEAPS call as collateral.
Are poor mans covered calls worth it?
Yes, they can be worth it for investors looking for a cost-efficient way to generate income and participate in the potential upside of a stock. They require less capital than a traditional covered call strategy because you’re buying a long-term option instead of the stock itself.
What is the poor man’s covered call option level?
The poor man’s covered call is a level 2 options trading strategy. This means you would need to have level 2 clearance on your brokerage account, which generally requires understanding of option basics, a certain level of trading experience, and adequate funding in your account.
How do I get out of poor man’s covered call?
Exiting a poor man’s covered call position involves two steps. You would first buy back the short call option that you sold. Then, you would sell the long LEAPS call option that you bought initially.
Can you lose money on a covered call?
Yes, you can. While selling covered calls generates income through premiums, if the underlying stock falls substantially, you can experience losses that could offset the premium income and more. That being said, the risk is generally lower than owning the stock outright.
Do you need 100 shares to sell a covered call?
In a traditional covered call, yes, you would need to own 100 shares of the underlying stock for each call option you wish to sell. In a poor man’s covered call, however, you own a long-term option instead of the stock itself.
How to get rich with covered calls?
While getting “rich” may vary for different individuals, selling covered calls can be a way to generate consistent income. It’s all about selecting the right stocks, selling options with suitable strike prices and expiration dates, and managing risk effectively.
Why covered calls are bad?
Covered calls aren’t inherently bad, but they do cap your upside potential. If the underlying stock rallies significantly, you may miss out on potential profits because your shares can be called away.
Can you live off covered calls?
It is possible, but it depends on the size of your investment portfolio and your living expenses. Selling covered calls can generate consistent income, but it’s not without risks. Investors should thoroughly understand these risks before relying solely on this strategy for income.
Can you consistently make money selling covered calls?
Yes, selling covered calls can generate consistent income. However, this strategy is not a guarantee of profits. Market volatility, sudden price drops, and other factors can impact the effectiveness of this strategy.
What happens if a poor man’s covered call expires in-the-money?
If the short call option of a poor man’s covered call expires in-the-money, the shares will be “called away.” Since you don’t actually own the shares but a long-term call option, you can exercise your long-term call option to cover the obligation.
What is the most you can lose selling covered calls?
Theoretically, the most you can lose is the cost of purchasing the shares (or the long-term call in the case of a poor man’s covered call) minus the premium received. This would happen if the stock price fell to zero.
What are the pros and cons of covered calls?
Pros: It generates income, reduces the cost basis of stock ownership, and provides a small amount of downside protection. Cons: Profit potential is capped if the stock rallies, and substantial losses can occur if the stock price plummets.
How does a poor man’s covered call work?
A poor man’s covered call involves buying a long-term (LEAPS) call option, and then selling a short-term call option against it. The goal is to mimic a traditional covered call strategy but with a lower capital requirement.
What is the downside risk of covered calls?
The downside risk of covered calls is substantial if the underlying stock price drops significantly. The premium income provides only limited protection against a decline in stock price. It’s essential to manage risk effectively when using this strategy.