Written by Comprehensive Guide to the Poor Man’s Covered Call (PMCC)
A Poor Man’s Covered Call (PMCC) is an options strategy that mimics a traditional covered call but at a significantly lower cost. This is achieved by substituting the stock with a long-term call option, reducing capital requirements while retaining profit potential. Here’s an expanded guide, complete with detailed explanations and examples.
What is a Poor Man’s Covered Call?
A Poor Man’s Covered Call involves two steps:
- Buying a Long-Term Call Option (LEAPS): A deeply in-the-money (ITM) call option with an expiration date typically 6 months to 2 years in the future.
- Selling a Short-Term Call Option: A near-term out-of-the-money (OTM) call option against the LEAPS to generate income.
This setup reduces the capital outlay compared to buying 100 shares of the stock while providing similar exposure to price movements.
Steps to Implement a Poor Man’s Covered Call
1. Select the Right Stock
Before executing a PMCC, you need to identify suitable stocks.
| Criteria | Details |
|---|---|
| Price Stability | Look for stocks with moderate to low volatility to manage risk effectively. |
| Dividend Payments | Avoid dividend-paying stocks as LEAPS holders are not entitled to dividends. |
| Strong Fundamentals | Focus on companies with strong growth potential to benefit from price appreciation. |
Example:
- Stock: ABC
- Current Price: $50
- Characteristics: Moderate volatility, strong earnings, no dividends.
2. Buy a Long-Term LEAPS Call
LEAPS (Long-Term Equity Anticipation Securities) are options with expiration dates typically more than a year away.
| Factor | Details |
|---|---|
| Expiration | Choose an expiration 6–24 months away for better stability and time value. |
| Strike Price | Pick a deep in-the-money (ITM) strike with a delta of 0.7–0.85, indicating strong price sensitivity. |
Example:
- Stock Price: $50
- LEAPS Strike Price: $35
- Expiration: 18 months
- Cost (Premium): $18 (or $1,800 for one contract controlling 100 shares).
3. Sell a Short-Term OTM Call
Selling a short-term out-of-the-money (OTM) call generates income through premiums.
| Factor | Details |
|---|---|
| Expiration | 1–6 weeks out. |
| Strike Price | Slightly above the current stock price (e.g., 5–10% higher) to balance premium and profit. |
Example:
- Stock Price: $50
- Short Call Strike Price: $55
- Expiration: 30 days
- Premium Received: $2 (or $200 for one contract).
Example Trade Setup: Poor Man’s Covered Call
| Step | Details |
|---|---|
| Buy LEAPS (Long Call) | Buy 1 ITM call with a $35 strike, expiring in 18 months for $1,800. |
| Sell Short-Term Call | Sell 1 OTM call with a $55 strike, expiring in 30 days for $200. |
| Net Cost | Initial cost: $1,800 (LEAPS) – $200 (premium received) = $1,600. |
Why Use the Poor Man’s Covered Call?
| Advantage | Explanation |
|---|---|
| Lower Capital Requirement | Costs significantly less than buying 100 shares outright. |
| Leverage | Gain exposure to price movements without full stock ownership. |
| Income Generation | Regularly sell calls to generate premium income and reduce cost basis. |
| Flexible Strategy | Adjust strike prices or expirations based on market conditions. |
Risks of a Poor Man’s Covered Call
| Risk | Details |
|---|---|
| Time Decay (Theta) | LEAPS lose value as expiration approaches, especially if the stock price stagnates. |
| Uncapped Loss on Short Call | If the stock price surges, the short call may incur losses that exceed the premium collected. |
| Stock Price Decline | A significant drop in the stock price reduces the value of the LEAPS option. |
Risk Management Tips:
- Monitor the position regularly.
- Roll the short call to a higher strike or later expiration if the stock price rises sharply.
- Close the position if the stock price declines significantly to minimize losses.
Scenario Analysis
| Stock Price at Expiration | Outcome for LEAPS | Outcome for Short Call | Net Result |
|---|---|---|---|
| $45 | LEAPS value drops but retains some ITM value. | Short call expires worthless. | Loss on LEAPS, but premium offsets some loss. |
| $54 | LEAPS gains value. | Short call expires worthless. | Moderate profit from LEAPS and premium. |
| $56 | LEAPS gains value. | Short call is exercised; premium limits loss. | Profit from premium and LEAPS. |
Tax Implications
| Component | Tax Treatment |
|---|---|
| LEAPS Gains | Taxed as long-term capital gains if held over 1 year. |
| Short Call Premiums | Taxed as short-term income, regardless of holding period. |
Conclusion
The Poor Man’s Covered Call is a flexible, cost-efficient strategy for investors seeking income and capital appreciation. By understanding the mechanics, risks, and tax implications, you can optimize this approach for your portfolio.
*Disclaimer: The content in this post is for informational purposes only. The views expressed are those of the author and may not reflect those of any affiliated organizations. No guarantees are made regarding the accuracy or reliability of the information. Use at your own risk.