One of the most popular options concepts you will hear early and often are covered calls.
Since most of my readers already own shares of a stock, you are selling calls against those shares.
It is one of the easier strategies to implement, but the main issue with covered calls is capital.
In order to sell a call, you need to hold at least 100 shares of a stock.
For some of my readers, that is a hard number to get to, especially with how expensive stocks have become.
You are in luck today, because there is an alternative to covered calls, and it’s a cool one.
The options world has long referred to this as a poor man’s covered call.
A poor man’s covered call is quite frankly the same thing as a covered call, with one exception.
Rather than buying 100 or more shares of the a particular stock, and investor will buy an ITM (in the money) LEAPS call and sell a near-term OTM (out of the money) call against it.
LEAPS are longer-term options. The term stands for “Long-term Equity AnticiPation Securities,” in case you’re the kind of person who wonders about that sort of thing. And no, that capital P in AnticiPation wasn’t a typo, in case you’re the kind of person who wonders about that sort of thing too.
Options with more than 9 months until expiration are considered LEAPS. They behave just like other options, so don’t let the term confuse you. It simply means that they have a longer “shelf-life”, offering more time exposure to the buyer.
Other than reducing the capital required, the reason we purchase LEAPS is to minimize the time value. For my more discerning readers, a poor man’s covered call can be viewed as a diagonal trade with a much longer duration.
How Should You Approach Your Own Poor Man’s Covered Call
First and foremost, and this works like your run of the mill covered call strategy – let’s choose a low-beta stock with low volatility.
I did a quick scan of Barcharts and found Cisco Systems (CSCO)
CSCO is a perfect example of a low-beta, blue chip stock you want to use for a poor man’s covered call strategy.
The next step is to choose an appropriate LEAPS contract to replace buying 100 shares of CSCO stock.
If we were to buy GE stock at $37.90 per share, our capital requirement would be a minimum of $3,790 plus commissions ($37.90 x 100 shares).
If we look at CSCO option chain, we will quickly notice that the expiration cycle with the longest duration is the January 2019 cycle, which has roughly 399 days left until expiration.
With the stock trading at $37.90, I prefer to buy a contract that is in the money at least 10%, if not more. Let’s use the $32 strike for our example.
We can buy one options contract, which is equivalent to 100 shares of CSCO stock, for roughly $6.65, if not cheaper. Remember, always use a limit order – never buy at the ask price, which in this case is $6.70.
If we buy the $32 strike for $6.65 we are out $665, rather than the $3,790 we would spend for 100 shares of CSCO. That’s saves us on capital required by 82.4%.
Now we have the ability to use the capital we saved in this poor man’s covered call ($3,125) to work in other ways.
The next step is to sell an out-of-the-money call against our LEAPS contract.
It seems as though the only call strike worth selling in CSCO is the January $39 strike with 63 days left until expiration. If we chose a stock with a slightly higher price we could go out two, three, four or more strikes away from the current price of the stock. But, I want to use a very conservative example so we understand the basic risk/reward.
So, let’s say we decide to sell the $39 strike for $0.72, or $72, against our $32 LEAPS contract.
Our total outlay or risk now stands at $593 ($665 LEAPS contract minus $72 call).
The greatest benefit to over this strategy is that we can sell calls against this LEAP contract every single month to lower the capital outlay. Keep in mind that options have a limited life, and the closer we get to the expiration, we will either sell the contract and use those proceeds to continue this strategy.
— The Option Specialist