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Covered calls are a low-risk way to earn money on a stock you currently hold and plan to hold indefinitely. But, there are also poor man’s covered calls which are a cheaper way to trade covered calls with a similarly low risk, where you do not need to hold the assets you are trading.
So what is a poor man’s covered call, and how does it work?
For a poor man’s covered call you will buy a long term call option (leap) and then sell a call against that option. Since you have an option to buy a call further out your position is covered by that call that you own.
In the real world it will look like this: You buy an ABC $25 January calls for $2 spending a total of $200. You then sell a July call $25 for .50 gaining $50.
Ideally the stock price will increase to around $25 by July and you will then be able to resell the call again in August, September, October, November, December, and January. If you are able to sell each call for .50 then you will make $150 on your original $200 investment.
As long as you are able to sell the call for 4 months then you will recoup your original investment and any other sales are profit.
That’s how a poor man’s covered call works. It is called that because instead of having to spend the $2,000 on 100 shares of a $20 stock you just have spend the much lower $200 on buying the long option.
This allows you to write a covered call for much cheaper than owning the actual stock.
In this article I will try to explain further what the difference is between a standard covered call and a poor man’s covered call. You will also learn when you can profit or lose money on your poor man’s covered call.
Covered Calls Vs. Poor Man’s Covered Call
Poor man’s covered calls are a type of covered call. They are cheaper than standard covered calls because you are not buying the stocks or other assets; you are just buying and selling calls.
Covered calls, including poor man’s covered calls, are also less risky and offer a high reward if you can trade them correctly.
Covered calls are when you hold a long position asset, usually a stock, then sell call options against that stock as a way to make money while you are holding the asset.
Covered calls are best for stocks that you expect to have very small price fluctuations in the near future, and you plan to hold for the long term.
The big difference between covered calls and poor man’s covered calls is that you do not actually own the stock you are selling calls for with poor man’s covered calls.
Instead, you are buying call options yourself in case the options you sell are exercised.
Your profit on a poor man’s covered call will depend on the strike price of the call. The highest profit you can get is the price received for the call plus the difference between the strike price and the price you paid for the calls purchased.
As long as the stock price does not meet the strike price before it expires, you will earn the maximum profit.
Poor man’s covered calls are a great way to make money without having to actually purchase stock. And, if you do need to purchase the stock, you can at a set price because of the calls you purchased.
However, as explained in the next section, you can face losses if the stock price drops past a certain point making it where you cannot sell multiple covered calls.
I will go into more detail about what happens if the stock price changes by a lot below.
What if the Stock Price Changes Significantly?
With poor man’s covered calls, you are not expecting the stock price to change much, if at all. So, if you are correct, you will not have to exercise the call option you bought because the call option you sold will expire with no value.
You will still earn money on the call options that you are selling.
However, if you are wrong and the stock price changes significantly, you will either lose money or not reach the highest profit you could have had if you did not sell the call options and just held the stocks or your own purchased call options.
You will make less than the maximum profit or even lose money on your poor man’s covered call if the strike price is reached before the call expires. If the call is exercised and the current stock price equals the strike price, you will begin to see your profit decrease.
You will see a net gain of zero if you spent the same amount of money buying your call plus the strike price of that call is equal to the premium you earned from selling the call plus the strike price of that call.
While you do not make any money in this situation, you are also not losing any money or missing out on a larger profit than you could have made.
If the difference between the strike price of your purchased call and the current market price is above your maximum profit, you would have been better off not using a poor man’s covered call and just holding and exercising the call that you bought.
While this does not affect the actual money you have to pay from the loss, it could have given you a higher overall profit, affecting what is considered your net loss.
Let me give another example to try and make this a bit clearer.
Let’s go back to the ABC company I mentioned above. If you paid $2 for that $20 call and then sold a $25 strike price call for .50 then your maximum profit if the stock price skyrockets would be $3.50 (or $350). That would be because you would have to use your call to cover the call that you sold that would be exercised.
So if the stock went to $30 you would miss out on $6.50 profit (or $650) if the stock jumped up.
In an ideal world the stock would rise to near $25 but not surpass it on the expiration date. Then you could resell a $25 option for the next month out or even move up a strike price if you thought the stock would go up further.
Now what happens when the stock price goes down?
Let’s say that ABC stock dropped drastically after you sold the call. Now your call that you sold would expire worthless so you would be down $150 (or the $2 that you paid minus the .50 premium that you collected)
You would basically have two options in this scenario. Sell the long term option that you bought for whatever you can get (likely at a loss) and move on to another trade.
The second option would be that you hold on to the long term call and hope that the stock price comes back up before the expiry. If it does then you can either profit on the call or start selling covered calls against it again.
If it doesn’t come back up before the long term call expires then you will lose the entire $150.
Learn More About Covered Calls
Here are some great books that will teach you more about covered calls and how to trade them.
- Covered Calls for Beginners: A Risk-Free Way to Collect “Rental Income” Every Single Month This book covers the basics of covered calls and how you can write them for a large profit. Much of the book can be applied to poor man’s covered calls as well, like how to choose stocks for your covered calls and how to choose your strike prices.
- The Options Wheel Strategy: The Complete Guide To Boost Your Portfolio: This book gives you strategies to use when you start trading any type of covered calls, some real-life examples of covered calls, and what stocks are good to start with for writing covered calls.
A poor man’s covered call is like a standard covered call, but instead of owning the stock or other asset, you are selling call options for, you are also buying a call option for yourself.
A poor man’s covered call is a low-risk investment with the possibility of a decently high return especially if the stock moves how you think it will.
But, you need to choose the right stocks and calls if you want to be successful. Otherwise, you will lose money and waste your time trading them.
So you need to know the best stocks and strike prices for poor man’s covered calls before investing.