Covered Call is a popular way to improve returns on long term investments. But selling Covered Calls requires a lot of buying power to execute, so there's something called a Poor Man's Covered Call strategy to help you make similar returns using less capital investment.
Today SlashTraders will show you how to execute Covered Calls with less buying power.
What Is a Covered Call?
A common Covered Call works by holding 100 stocks while selling an OTM Call options that expires next month to increase the returns on the buy and hold strategy.
When we invest in BABA with the Covered Call options strategy, the trade uses $8,495 in buying power:
- Buy 100 stocks.
- Sell a 0.20 delta OTM Call option at $110 that expires next month.
The trade can earn the short Call premium of $231 if the stock price doesn't rise beyond $110 before expiration. If the stock price rises beyond $110, the maximum profit on the Covered Call is $2,405.
If we don't want to spend so much cash on a single trade, we can use the Poor Man's Covered Call to achieve a similar result.
What Is a Poor Man’s Covered Call?
A Poor Man's Covered Call on BABA uses only $3,825 in buying power, less than half of the Covered Call:
- A 0.90 delta long Call at $50 that expires 5 months later.
- A short 0.20 delta OTM Call at $110 that expires next month.
If the stock prices doesn't rise beyond $110 before expiration, we profit $231 from the short Call premium. If the stock price goes up beyond $110, the maximum profit from the Poor Man's Covered Call is $2,175.
However, if the stock price drops below $50 within 5 months, the value of the options strategy becomes worthless.
Differences Between Poor Man’s Covered Call and a Normal Covered Call
The advantage of a Poor Man's Covered Call is to earn similar profits with less capital investment.
From the BABA example we showed earlier, the Poor Man's Covered Call uses less than half of the buying power to earn the same short Call premium.
|Strategies||Buying power||Short Call premium (%)||Maximum profit (%)|
|Covered Call||$8,595||$231 (2.7%)||$2,405 (28%)|
|Poor Man's Covered Call||$3,825||$231 (6.0%)||$2,175 (57%)|
If the stock price shoots up, the Poor Man's Covered Call gives us a higher Return on Capital.
But if the stock price falls unexpectedly, the Covered Call trader can patiently wait for the stock to rebound in the future. On the other hand, the Poor Man's Covered Call trade needs to close before the options expire, giving us less time to respond when the market goes down.
How to Find the Best Poor Man’s Covered Calls to Enter
We choose Poor Man's Covered Call opportunities like we do with the popular version, by finding blue-chip stocks that we want to invest in long term.
The Bullish Value Stocks list shows us undervalued, blue-chip stocks that have a high probability of going up.
We can see PayPal is heavily undervalued right now. Compared to Fair Value from the fundamental analysis, there is 123% of potential Upside.
The technical analysis also tells us PYPL has a bullish signal 1 trading day ago, shown by the Long Signal Days of 1.
A Poor Man's Covered Call on PYPL costs $3,430 in buying power:
- Buy a 0.90 delta ITM Call option at $45 that expires 5 months later.
- Sell a 0.20 delta Call option at $95 that expires next month.
We can make $133 from the short Call premium if the stock prices doesn't reach $95 by next month. If the stock prices goes beyond $95, the maximum profit from the trade is $1,570.
Even though a normal Covered Call is a low risk options strategy that boosts returns on long term investment, but it requires a great capital investment. We can use Bullish Value Stocks to find Poor Man's Covered Call opportunities to reduce the buying power by half to earn the same potential profits.