Poor Man's Covered Call: How the Trade Dey Work

Poor man's covered call dey replace 100 shares inside a covered call with one deep in the money call option wey get expiry one year or more from now. Then e sell another call wey get shorter expiry against am to collect premium. The long call dey do the work wey the stock for do, but na small part of the cash e need. The formal name na long call diagonal spread: two calls on the same stock, with different strikes and different expirations.

Poor man's covered call na wetin, leg by leg?

The long leg na call wey get 9 to 24 months before expiry. E get strike well below the current share price, and dem dey choose am with delta near 0.80 to 0.90. Delta near 0.85 mean say the contract fit gain about $0.85 for every $1 wey the stock gain. Na close to owning the stock as option fit be. Contracts wey get that long expiry na LEAPS. The deep strikes especially na subject of deep in the money LEAPS.

The short leg na call wey get 20 to 60 days before expiry. E get strike above the current share price. You collect the credit upfront. If the stock finish below that strike when e expire, the contract expire worthless. You keep the credit and sell another one against the same long call. Na that repetition dey provide the income part of the structure.

Why the long call must dey deep in the money

Call wey get strike near or above the share price no dey move as much as the stock. The short call wey you sell against am fit move pass am when the stock rally. The deeper the long strike dey in the money, the closer the contract dey track the share price dollar for dollar. Call wey get at-the-money strike normally get delta near 0.50. That mean e move about half dollar for every dollar wey the shares move. But strike deep enough to price at 0.85 delta make the long leg move almost together with 100 shares.

Depth get cost for the other side of the trade. Long-dated deep strikes often dey trade with small volume. Thin volume dey show as wide gap between bid and ask. You pay that gap when you enter and again when you exit. Liquid against thinly traded options explain wetin that gap cost.

How much capital e really save?

The outlay na the price of the long call minus the credit wey you collect from the short call. You compare am with the full price of 100 shares. The worked example for the next section calculate am with round numbers.

Smaller outlay no mean smaller risk. Make we talk am plainly. Shares wey you buy at $100 still worth $8,000 if the stock fall to $80. Call wey get $80 strike worth nothing at $80 on the day wey e expire. The dollar loss smaller. But the loss on the money wey you commit fit be total.

The coverage rule wey most walkthroughs leave out

Real covered call no fit lose on a rally because you already own the shares wey you fit need deliver. The option version only get that same protection when one inequality hold.

Long strike plus net debit must be less than or equal to short strike.

Net debit na wetin you pay for the long call minus the credit wey you collect from the short call. Make we work am with round hypothetical numbers. The stock dey trade at $100, so 100 shares go cost $10,000.

• Buy the 500-day $80 call at $25.00: na $2,500 debit. Out of that amount, $20.00 na intrinsic value and $5.00 na time value.
• Sell the 45-day $110 call at $1.50: na $150 credit.

That one leave net debit of $23.50 per share, or $2,350 for the position. Na 23.5% of wetin the shares cost. Run the check: 80 plus 23.50 equal 103.50, against short strike of 110. E pass the test by $6.50 per share. That $6.50 na exactly the capped profit.

This na the position when the short call expire, with the long call valued only at intrinsic value. Na deliberate floor. Since more than one year remain, the long call still go get time value at all these prices. So the real marks go dey above these figures.

• Stock at $70: the position down $2,350, while 100 shares down $3,000.
• Stock at $80: down $2,350, while the shares down $2,000.
• Stock at $90: down $1,350, while the shares down $1,000.
• Stock at $100: down $350, while the shares flat.
• Stock at $110: up $650, while the shares up $1,000.
• Stock at $130: up $650, while the shares up $3,000.

Now break the rule. Sell the 45-day $100 call for $3.00 instead of the $110 call. The net debit go fall to $22.00, and 80 plus 22.00 equal 102.00 against short strike of 100. The check fail by $2.00 per share. If the stock dey at $130 when the short call expire, the short call owe $3,000. The long call get $5,000 intrinsic value. Unwinding both return $2,000 against the $2,200 wey you pay. Na $200 loss on a $30 rally, from position wey look covered on the screen. The gap in the inequality na the loss per share every time.

The cap too deserve calculation. $650 on $2,350 committed na 27.7%. The same short call wey you sell against $10,000 worth of stock gives $150 credit plus $1,000 share appreciation. That one na 11.5%. The percentage bigger on the smaller base, and the percentage wey fit go to zero bigger too. Covered call return math work the share-version denominator one by one.

Where e stop to behave like covered call

E no collect dividends

Dividends go to the holder of record of the shares. Call holder no be shareholder until e exercise the call, so the cash pass am by. The panel measure wetin 6 well-known payers give 100-share owners over the trailing year.

SELECT
    ticker                                   AS symbol,
    round(sum(toFloat64(cash_amount)) * 100, 2) AS annual_cash_on_100_shares,
    count()                                  AS payment_count
FROM
(
    SELECT
        ticker,
        id,
        any(cash_amount) AS cash_amount
    FROM global_markets.stocks_dividends
    WHERE ticker IN ('AAPL', 'MSFT', 'KO', 'JNJ', 'XOM', 'SPY')
      AND ex_dividend_date >= today() - 365
      AND ex_dividend_date <= today()
    GROUP BY ticker, id
)
GROUP BY ticker
ORDER BY annual_cash_on_100_shares DESC

SPY lead the group with $752.5 on 100 shares across 4 payments. Poor man's covered call on that name no collect any of am. Dividends also change the chance of early assignment on the short leg. ex-dividend dates and options break down the matter.

The long leg dey decay too

Stock no dey expire. Long call dey expire, and the time value inside am dey reduce toward zero as time pass. Deep in the money strike get less time value per dollar committed than strike wey dey closer to the money. Na part of the reason people choose depth. But the time value no be zero, and e dey erode as the contract dey age.

Decay dey fastest during the final weeks of a contract and slowest during the early period. Na that shape the diagonal dey use: the short leg dey inside the fast period, while the long leg dey inside the slow period. Every short call wey you sell and allow to expire collects part of the fast decay against the long leg wey dey give up the slow decay. How option greeks change over time trace the process contract by contract.

Assignment force you to choose

When the stock dey above the short strike, the short call fit get assigned. Assignment fit happen before expiration, no be only on expiration date. Then you owe 100 shares wey you no get. One option na to buy them at the market price. That one bring back the capital wey the structure suppose help you avoid. The other option na to exercise the long call and use the shares deliver them. But you go give up every cent of the time value still priced inside the long call. Selling the call captures that value; exercising am returns the value. Early assignment on short options explain when the risk dey gather. The session before an ex-dividend date na the classic example.

Frequently asked questions

Poor man's covered call na wetin?

Na long call diagonal spread wey people use instead of covered call. One deep in the money call wey get one year or more before expiration stand in for 100 shares. Then dem sell shorter-dated out of the money call against am. The long call provide the exposure. The short call provide the premium.

How much capital poor man's covered call need?

The outlay na the price of the long call minus the credit from the short call. For the worked example above, $2,500 long call against $150 credit commit $2,350 instead of the $10,000 wey 100 shares cost. That na 23.5% of the share price.

Poor man's covered call always dey covered?

No. E fully covered only when long strike plus net debit dey at or below short strike. When that sum dey above short strike, rally past the short strike go produce loss, even though long call nominally dey back the short call.

You dey get dividends with poor man's covered call?

No. Dividends go to the holder of record of the shares. Call holder no be shareholder until e exercise the call. The dividend panel above measure how much cash that one add up to on 100 shares over one year.

Wetin happen if dem assign the short call?

You owe 100 shares. You fit buy them at market price, or exercise the long call to deliver them and give up the time value wey still dey priced inside am. The second option close the long leg and end the structure.

The panel here come with the exact SQL underneath am. Open am, change the ticker, and run the same measurement on any name wey you dey study for the Strasmore terminal.