One of the simplest option strategies is covered call. This is a strategy that assumes that call options are written on a basket of stocks with a strike price above the market (i.e. OTM option). In the case of a positive scenario (increase in the share price to the strike price of the option sold), the investor receives an "additional dividend" in the form of a retained premium. The covered call strategy requires the involvement of large capital. However, there is a strategy that works similarly to a covered call but requires less capital investment. The strategy is named Poor Man Covered Call (PMCC) or also Poor Man Covered Option (PMCO). In today's article, we will explain how to create this strategy and what are the advantages and disadvantages.

READ NECESSARY: What are options - an introduction

Poor Man Covered Call - how to build this strategy?

Although the name may suggest that the strategy is "for the poor", it can be a very useful tool that optimizes the capital invested in a given company by the investor. The strategy consists in buying a long-term call option (LEAPS) and writing a call option with a shorter execution date. LEAP option should be deep ITM. This means that the option has a high intrinsic value and a high delta. It is therefore a substitute for holding company shares for a long term.

On the other hand, the issued call option, which is OTM. The expiration date of a written option is much shorter than that of a LEAPS option. As a result, a strategy with parameters similar to the classic covered call is created. The difference is lower demand for capital, which can increase the rate of return on investment. What's more, the "saved" capital can be invested in another PMCO. In this case, the investor uses the financial leverage that he has "built-in stop loss". The investor cannot lose more than the capital invested in the LEAPS option.

For example, an investor purchased a call option with an exercise price of $12 and an expiration date of June 100 on September 2024, and a call option with an exercise price of $155 that expires in March 2023. For the purchased option, the investor paid $50,5 (per 1 share), z  option issued, he received $8,25 (per 1 share). The results of the strategy are presented below.

Source: own study

It is worth remembering that the acquisition of LEAPS is aimed at investors with a longer investment horizon. For those who are afraid of a significant drop in the share price, you can apply collar strategy, which also includes the purchase of a put option, which protects against a sharp drop in the share price to which the investor is exposed.

The advantage of PMCC - risk reduction

Another strength of the strategy is the protection of the investor against a sharp drop in the stock on which the call option is issued. In the classic strategy, the worst situation is when the scenario of a sharp decline in the stock price comes to fruition. A drop in the value of shares by 70-80% means that a few percent profit on the issued call option is little consolation for the investor. Companies are an example of this Peloton. The company's shares have fallen 94% over the past year.

Rapid declines do not only concern smaller companies. Also Amazon had experienced significant declines in the last few months. On September 12, 2022, Amazon shares traded at around $136. The investor considered two strategies:

• A: buying 100 shares and issuing call options expiring in March 2023,
• B: buying 1 call option expiring in June 2024 and writing call options expiring in March 2023.

In the case of strategy A, the investor initially invests $13 and receives $600 from writing a call option with a strike price of $825 and expiring in March 155. So the investment requires an initial investment of $2023. On January 12, one Amazon share was $775. This meant that the loss on Amazon stock was $6 per share, or $86. The loss on the position amounted to 50%. Due to the decline in the share price, Amazon caused the price of the call option to drop from $5 to $000. Thus, the profit on the call option was $36,7. The loss from the entire strategy was $8,25.

Strategy B was much less expensive. An investor bought 1 call option with an expiration date of June 2024 and an exercise price of $100. On September 12, 2022, the price for this option was $50,5. This meant that the investor had to invest $5050, which is 62,9% less than in the case of buying 100 Amazon shares. Writing a call option with a strike price of $155 and expiration in March 2023 gave the investor $825. As a result, the net purchase price was $4225.

Until January 6, the downward trend in Amazon shares continued. Within a few months, the share price of the largest e-commerce platform in the United States fell from $136 to $86. This resulted in a decline in the value of call options. The price of the LEAPS option fell from $50,5 to $13. This means a decrease of 74%, i.e. $3. At the same time, the profit from the issued call option amounted to $750. Thus, the loss of the entire portfolio was $815, i.e. 2935%. In percentage terms, the decline was larger, but in nominal terms, the investor lost $1250 less than in the case of the classic covered call strategy.

The disadvantage of PMCC - lack of flexibility

The big disadvantage of the transaction is the lack of flexibility. An investor cannot create a portfolio with any number of stocks. Stock options usually have a multiplier of 100. Therefore, the minimum nominal position is 100 shares of a given company. This creates problems when an investor wants exposure to a specific number of stocks.

Another problem associated with the use of LEAPS options is a smaller delta than in the case of a classic purchase of company shares. One stock has a delta of 1, while ITM options with high intrinsic value have a delta of 0,80 to 0,95.

Summation

This is a synthetic long position with a limited loss. The investor can only lose the value of the paid call option. The big advantage of such a strategy is less capital that is needed to create the strategy.

The best opportunity to create a Poor Man Covered Call is when stock prices are low and volatility is low. In this case, buying a long-term call option will be "cheaper" than in times of higher volatility. It is also worth remembering that holding a call option that is a LEAPS does not mean that the investor must write call options for the entire life of the long-term option. It is much better to wait to write a call option at a time when implied volatility is high and stocks are already on a strong uptrend.

When using PMCC, there is no need to use long-term call options, but it is worth their expiration period to be longer than 90 days. Then the passage of time will not be devastating for the investor's portfolio.

Do you know that…?

Saxo Bank is one of the few Forex brokers that offers vanilla options. The investor has a total of over 1200 options at his disposal (currencies, stocks, indices, interest rates, raw materials). CHECK