Covered calls are one of the most popular options strategies for generating income. However, they come with a significant barrier: the requirement to own 100 shares of a stock or ETF, which can demand substantial capital. For instance, writing a covered call on an ETF like SPY, priced at over $300 per share, would necessitate over $30,000 in capital. This makes covered calls less accessible to many retail investors. The poor man’s covered call solves this problem by substituting stock ownership with a deep in-the-money (ITM) LEAP (Long-term Equity AnticiPation Securities). This strategy mimics the income-generation ability of covered calls while drastically reducing the capital needed to initiate the position.

In this comprehensive guide, we will dive deep into the poor man’s covered call, examining its structure, advantages, risks, and practical applications, while providing examples and strategies to help traders execute it effectively.

What is the Poor Man’s Covered Call?

The poor man’s covered call is a derivative-based strategy designed to replicate the functionality of a covered call. Instead of buying and holding a large quantity of stock, the investor purchases a LEAP, which acts as a substitute for the stock. This is followed by selling a short-term call against the LEAP.

Key Components:

1. LEAP as a Stock Substitute
   • A LEAP is a long-term call option with an expiration date extending over a year. It gives the buyer the right to purchase the underlying asset at the strike price before the expiration.
   • A deep ITM LEAP is chosen to ensure that the option behaves like the stock, as its Delta (rate of price movement relative to the stock) is close to 1. This means the LEAP will mimic the stock’s price movements.
2. Selling a Short-Term Call
   • A short-term, slightly out-of-the-money (OTM) call is sold to generate income. The premium collected from selling this call reduces the net cost of holding the LEAP and provides potential profit.
   • The call is selected with an expiration of 30–45 days, which balances premium collection with time decay (Theta).

How Does It Work?

The poor man’s covered call strategy has two primary steps: buying the LEAP and selling the short-term call.

Step 1: Buying the LEAP

The LEAP serves as a cost-effective proxy for owning the underlying stock. A deep ITM LEAP is chosen because:

• It has significant intrinsic value, minimizing the effect of time decay.
• It closely tracks the price movements of the stock, behaving like a long position.

Example:
If SPY is trading at $326, a deep ITM LEAP with a strike price of $288 expiring in June 2021 might cost $46. This LEAP gives the right to buy SPY at $288, acting as a synthetic substitute for owning the stock.

Step 2: Selling the Short-Term Call

A short-term call is sold against the LEAP to generate income. The call should be slightly OTM, allowing the investor to collect a meaningful premium while keeping the stock within a reasonable price range.

Example:
A short-term call with a strike price of $331 expiring in September 2020 could generate a premium of $3.94. Selling this call offsets the cost of the LEAP and provides additional income.

Net Cost Calculation:

• Difference between strikes = $43.
• Total upfront cost = ($43 + $3.94) – $46 = $1.94 (or $194).

This reduces the initial investment significantly compared to owning 100 shares outright.

Advantages of the Poor Man’s Covered Call

The poor man’s covered call offers several advantages, making it appealing to traders with limited capital.

1. Lower Capital Requirement

The traditional covered call strategy requires owning 100 shares of a stock or ETF. This can cost tens of thousands of dollars, depending on the stock price. For example, owning 100 shares of SPY would require $32,600.
The poor man’s covered call reduces this to the cost of one LEAP, which may only require a few thousand dollars. This makes it accessible to retail investors who may not have large amounts of capital.

2. Income Generation

The strategy generates income through the sale of short-term calls. This income can offset the cost of the LEAP, lower the breakeven point, and provide consistent returns.

3. Leverage

The LEAP provides exposure to the stock’s price movements at a fraction of the cost. This allows investors to control a larger position with less capital, enhancing potential returns.

4. Volatility Advantages

LEAPs are more sensitive to changes in implied volatility, as measured by Vega. An increase in volatility significantly boosts the value of a LEAP compared to short-dated options.

5. Flexibility

The LEAP can be held for years, giving investors the ability to adjust their strategy based on market conditions. This long-term horizon provides flexibility to roll or modify positions.

Risks and Considerations

Despite its advantages, the poor man’s covered call comes with certain risks and considerations.

1. Market Risk

If the underlying stock declines significantly, the LEAP’s value will decrease. Although the premium from the short-term call provides some cushion, it may not fully offset the loss in the LEAP.

2. Assignment Risk

The short-term call may move in-the-money, triggering an assignment. This requires the investor to deliver the stock. In such cases, the LEAP must be exercised to meet the obligation, potentially resulting in losses.

3. Limited Upside

The sold call caps the upside potential. If the stock rallies sharply, the gains are limited to the difference between the strikes and the premium collected.

4. Theta Decay

LEAPs are less sensitive to Theta decay compared to short-term options, but holding them for long periods without favorable price movements can erode their value.

5. Complexity

Executing and managing the poor man’s covered call requires a deep understanding of options pricing, Greeks (Delta, Theta, Vega), and market trends. This complexity may be challenging for novice traders.

Practical Applications

The poor man’s covered call is best suited for specific market conditions and can be adapted to different scenarios.

Ideal Market Conditions

1. Bull Markets: The strategy thrives in markets with moderate upward trends, where the underlying stock steadily appreciates.
2. Neutral Markets: In flat markets, the income from selling calls becomes the primary source of profit.

Strategy Adjustments

1. Rolling the Short Call:
   If the stock approaches the short call’s strike price, the call can be rolled to a higher strike or later expiration. This allows the investor to maintain the strategy while adjusting for market conditions.
2. Exiting the Position:
   The LEAP can be sold, and the short call can be bought back to exit the strategy. This is often done to lock in profits or cut losses.

Real-World Example: SPY ETF

Using the SPY ETF as the underlying asset, here’s how the poor man’s covered call could work:

1. Purchase a LEAP:
   • Strike Price: $288
   • Expiration: June 2021
   • Cost: $46
2. Sell a Short-Term Call:
   • Strike Price: $331
   • Expiration: September 2020
   • Premium: $3.94

Outcomes

1. Stock Rises Above $331:
   The short call is exercised, and profits are capped. The LEAP increases in value, but gains are limited to the difference between the strikes plus the premium.
2. Stock Remains Below $331:
   The short call expires worthless, and the premium is retained. A new call can be sold to generate additional income.
3. Stock Declines:
   The LEAP loses value, but the premium offsets some of the losses.

Greeks and Key Metrics

1. Delta

The LEAP should have a Delta close to 1 to mimic stock ownership.

2. Theta

LEAPs experience slower time decay, making them ideal for long-term strategies.

3. Vega

LEAPs are highly sensitive to changes in implied volatility, providing opportunities for profit in volatile markets.

Historical Performance of the Poor Man’s Covered Call

To understand the viability of the poor man’s covered call, it is essential to analyze its historical performance. The strategy has been particularly effective in markets with moderate upward trends or periods of low volatility. Here are a few scenarios demonstrating how the strategy performed in different market conditions.

Bull Market Scenario

In a bull market, such as the post-2009 recovery period or the tech-driven rally from 2020 to 2021, the poor man’s covered call worked well for stocks and ETFs with a steady appreciation.

• Example:
  • Stock: SPY ETF
  • Initial price: $300
  • LEAP purchase: $280 strike price for $25 premium (deep ITM, expiration 2 years out)
  • Short-term call sale: $310 strike price, collecting $2 premium per month

As the SPY gradually appreciated to $310, the strategy generated consistent monthly income, and the LEAP’s value increased. Although gains were capped by the sold calls, the strategy delivered predictable returns with minimal risk.

Sideways Market Scenario

During periods of low volatility or flat markets, such as 2015, the poor man’s covered call thrived because the short calls expired worthless, allowing investors to keep the premiums.

• Example:
  • Stock: XYZ trading around $100
  • LEAP purchase: $90 strike price for $12 premium (deep ITM)
  • Short-term call sale: $105 strike price, collecting $1.5 monthly premium

Over six months, XYZ fluctuated between $95 and $105, and the short calls expired worthless each time. The investor kept the premiums, gradually reducing the cost of the LEAP.

Bear Market Scenario

In bear markets, such as the 2008 financial crisis or the March 2020 COVID-19 crash, the poor man’s covered call struggled. While the short calls provided some income, the rapid decline in stock prices eroded the LEAP’s value.

• Example:
  • Stock: ABC trading at $200
  • LEAP purchase: $180 strike price for $30 premium
  • Short-term call sale: $210 strike price, collecting $2 premium

As ABC dropped to $150, the LEAP lost significant value, and the short call premium was insufficient to offset the losses.

Takeaways from Historical Performance

1. The strategy performs best in stable or upward-trending markets.
2. It struggles in high-volatility, declining markets due to the LEAP’s exposure to price movements.
3. Investors must closely monitor market trends and adjust positions to manage risks effectively.

Advanced Applications and Adjustments

The poor man’s covered call can be tailored to fit specific trading goals. Here are advanced applications and adjustments for the strategy.

Rolling the Short Call

Rolling involves closing an existing short call position and opening a new one with a later expiration or higher strike price.

• When to Roll:
  • If the underlying stock is approaching the strike price of the short call.
  • To avoid assignment while keeping the strategy intact.
• Example:
  • Original call: $310 strike, expiring in 30 days
  • New call: $320 strike, expiring in 60 days

Rolling generates additional income while maintaining the LEAP position.

Adjusting the LEAP

Investors may choose to replace the LEAP if market conditions change.

• Example:
  • Replace a deep ITM LEAP with one that has a slightly higher strike price to reduce cost.
  • Sell the original LEAP and use the proceeds to fund the new position.

Combining with Other Strategies

The poor man’s covered call can be combined with other strategies, such as vertical spreads or protective puts, to enhance returns or reduce risk.

• Example: Add a protective put to hedge against downside risk, creating a synthetic collar.

Tips for Successful Execution

Selecting the Right LEAP

1. Choose Deep ITM LEAPs: Ensure the strike price is far below the current stock price, so most of the LEAP’s value is intrinsic.
2. Delta Greater than 0.75: A high Delta ensures the LEAP behaves like the stock.

Selling the Right Short Call

1. Slightly OTM Calls: These provide a balance between premium collection and upside potential.
2. Expiration in 30–45 Days: Short-term calls experience rapid time decay, maximizing the income potential.

Monitoring Market Conditions

1. Volatility: High implied volatility increases premiums but also raises risk.
2. Price Trends: Adjust positions based on the stock’s movement.

Practical Real-World Examples

Example 1: Using SPY ETF

• Scenario: SPY trading at $400.
• LEAP Purchase: $350 strike, expiring in 2 years, costing $60.
• Short Call Sale: $420 strike, expiring in 30 days, collecting $5 premium.
• Outcome 1: SPY remains below $420.
  • The short call expires worthless. The investor retains the $5 premium and can sell another call.
• Outcome 2: SPY rises above $420.
  • The short call is assigned, capping the profit. The investor delivers the stock by exercising the LEAP, realizing gains.

Example 2: Using AAPL Stock

• Scenario: AAPL trading at $180.
• LEAP Purchase: $150 strike, expiring in 18 months, costing $25.
• Short Call Sale: $190 strike, expiring in 45 days, collecting $3 premium.
• Outcome 1: AAPL falls to $160.
  • The LEAP loses value, but the short call offsets some of the loss.
• Outcome 2: AAPL rises to $200.
  • The short call is assigned, and the profit is capped.

Comparing the Poor Man’s Covered Call with Alternatives

Traditional Covered Call

• Capital Requirement: Higher (e.g., $30,000+ for 100 shares of SPY).
• Risk: Losses capped at the stock’s cost basis.
• Return: Limited by the short call’s strike price.

Poor Man’s Covered Call

• Capital Requirement: Lower (e.g., $4,600 for one LEAP).
• Risk: Losses tied to the LEAP’s premium and stock movement.
• Return: Similar to covered calls but with less capital at risk.

Conclusion

The poor man’s covered call is an innovative strategy that democratizes options trading for retail investors. It combines the income-generating potential of covered calls with the cost efficiency of LEAPs, offering a powerful tool for income-focused traders.

However, like any strategy, it comes with risks. Market volatility, assignment risk, and limited upside potential are challenges that require careful management. With proper execution, monitoring, and adjustments, the poor man’s covered call can serve as a valuable addition to any portfolio.

This strategy is best suited for traders seeking steady income with lower capital requirements. Its success lies in understanding its mechanics, selecting the right options, and adapting to market conditions.

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