If you are thinking about pursuing a poor man’s covered call, you might be shooting your own investment strategy in the foot. That may sound like a harsh assessment, but we’re here to tell you why poor man’s covered calls are usually a bad idea. Keep reading to learn why the poor man’s covered call is dead on arrival.
What is a Poor Man’s Covered Call?
First, let’s define a call option. A call option is a contract that allows the option buyer to purchase the underlying asset (i.e. a stock) from the option seller for an agreed-upon price, called the strike price, and with an agreed-upon time frame, called the expiration date. Call options serve many purposes. They can be used to speculate on the price movements of the underlying assets, but they can also be used to help manage risk and volatility when performing other trades with the underlying asset.
A covered call option is when you sell a call option, but for every call option you sell, you also own the underlying asset. Thus, if the call option is ever exercised by the buyer, you as the seller, can deliver the shares you already own. Hence, it is called a “covered” call because the option is covered by the assets you already own.
Covered calls can act as a hedge on an investment you already own, they generate income by selling the options. Thus, if the underlying asset goes down, you at least make some return from income generated by selling the option. Hence, covered calls can be a good choice when you believe that the underlying asset is a good long-term investment, but it's near to mid-term price movements may be neutral to trending down. However, with every potential upside, there is always a downside, so let’s talk about that.
One of the main drawbacks of a covered call is that you must purchase the underlying shares to cover each call option you write, which can be very expensive, to the point that most individual investors will not have the necessary capital to execute the strategy.
This is where the poor man’s covered call comes in, which simulates the dynamics of a covered call but requires less capital. Instead of buying the shares outwrite to cover the calls you are writing, you purchase a long-duration in-the-money call option, which serves the same function as owning the shares outright but requiring much less capital.
How The Poor Man’s Covered Call Can Hurt You
At first glance, a poor man’s covered call may not sound damaging to your overall investment strategy, but this move often isn’t worth the effort you have to put into it.
In an ideal world, when the short out-of-the-money call option that you sold expires, it will be worthless because the equity price is lower than the strike price. This will give you the opportunity to retain the premium you made from writing that option and as the underlying stock’s price rises, the value of the long, in-the-money call option you hold will increase in value.
However, we don’t live in an ideal world and this is a risky strategy because if the asset price goes down, the value of the in-the-money call option that you hold will rapidly decrease in value. At this point, your losses will begin to mount and exceed the premium you made from selling the short out-of-the-money call options.
For example, let’s say stock X is currently trading at $200. You decide to buy a back-month call option with a strike of $190 and pay a premium of $25.00 per share. You then sell a 30-day call option with a strike of $205 and receive a premium of $10.00 per share.
To calculate the maximum potential loss, you would use this formula:
- Maximum Loss = ($25.00 − $10.00) × number of shares
If you bought and sold options on 100 shares, in this scenario your max loss would be $1,500 after all contracts expire.
From a strategy standpoint, a poor man’s covered call can take up a lot of your time that might be better spent on more effective investments. You have to actively manage poor man’s covered calls and pay close attention to stock and options positions. Staying on top of market movements and conditions is key and you need to be ready to make swift changes if necessary. At the end of the day, all this work may not pay off, especially considering how difficult it is to profit from a poor man’s covered call.
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