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The Poor Man’s Covered Call: What It Is & Why I Don’t Use It

An interesting strategy that most can do without.

I’ve written a lot about covered calls for three reasons:

• They’re a potentially powerful tool for cash flow
• They’re not complicated or dangerous
• Despite all the discussion around them lately, many (most?) investors still aren’t aware of their potential

However, I’ve generally neglected the “poor man’s covered call,” so it’s high time to take a look.

Done right, it can be a more capital-efficient way to realize similar cash flow to a standard covered call. Although I’m not much of a fan—more on that below—it’s still a strategy worth knowing about.

Photo by Marga Santoso on Unsplash

I’m not a financial professional. This is purely opinion and entertainment, not advice. Do what’s right for you, and if in doubt about what that is, then it’s important to find someone who’s legally able to tell you.

What is a poor man’s covered call?

A poor man’s covered call (PMCC) entails buying a longer-dated, in-the-money call option and writing a shorter-dated, out-of-the-money call option against it. It’s technically a spread, which can be more capital-efficient than a true covered call, but also riskier and more complex.

This isn’t the most intuitive strategy, but it’s worth understanding if only to broaden your knowledge of options.

Why does this work?

Think of shares as options with infinite time to expiration and a delta of 1.00. In other words, their price would move $1.00 for a $1.00 change in the underlying. (I know that’s circular, since they are the underlying, but this concept is important.)

Now, think of standard covered calls as using ∞-DTE, 1.00-delta “options” (i.e., shares) for collateral. Those attributes make the “options” expensive. But if we replace those shares with actual options—meaning an expiration date and lower delta—then our collateral is much cheaper!

This also increases risk, as we’ll see, but let’s look at an example of why the PMCC might appeal in the first place.

How does it affect profitability?

Done right, a PMCC is more capital-efficient: it can provide comparable cash flow from far less collateral. But with greater reward comes greater risk, namely the chance of the underlying call expiring worthless (“going to zero”) when shares would have kept their value.

Let’s say you’d like to write a covered call on AAPL, which trades for $172.07. You want to sell a $180, 0.34-delta call expiring 2022–02–18 for a premium of $3.56 ($356 credit).

(Prices are current as of drafting this section. They’ll change by the time you see it, but percentages should be roughly similar.)

• The traditional covered call requires $172.07 * 100 = $17,207 of collateral. If the short call expires worthless, the returns will be $356 / $17,207 = 2.1% on collateral.
• A PMCC against a 9-month, 0.90-delta call ($120 exp. 2022–10–21) sells for $55.30, for a capital requirement of $5530. If the short call expires worthless, the returns would be $356 / $5530 = 6.4% on collateral.

And that’s the gist of a poor man’s covered call (PMCC): you buy a longer-dated, deep in-the-money call option instead of 100 shares.

The lack of actual shares means this isn’t really a covered call. Strictly speaking, it’s a diagonal debit spread. This raises some complications:

• It requires additional options permissions and margin access from your brokerage. Level 1 (essentially the default) is sufficient for covered calls, but you’ll need level 3 for spreads like the poor man’s covered call.
• It’s more complicated to set up and manage. It introduces a second contract whose expiry and delta need to make sense relative to the short call. You may also need to manage this long call separately from the short call. Shares are simpler, period.
• It’s impossible to predict the exact P&L for a certain share price on the short call’s expiration date. And the more volatile the share prices between now and then, the less precise your estimate.
• It opens you up to some very unlikely but possible assignment problems (e.g., after-hours assignment on an in-the-money short call). I believe most brokerages will try to sell your long call to settle the position, but please correct me if I’m wrong. Regardless, it’s safer and less stressful to close/roll the short contract rather than letting it expire (as you might in a standard covered call).

Choosing stocks for a poor man’s covered call

Stock-picking criteria are roughly the same as for a standard covered call. If anything, I’d be even more conservative and stick to particularly stable underlyings.

That’s because shares can regain their value in the event of a dip in price. Be it next week or next year, they can and often do rebound. Long call options can regain their value, but a) it has to happen before expiration and b) it usually has to more than regain its old price to offset time decay.

Let’s say the underlying falls 20% and stays there for all eternity. Your shares would still retain 80% of their value and bring in whatever dividends the company issues. Not ideal, but far from a total loss.

But your call would simply go to zero, or nearly zero, depending on the strike you chose.

Consequently, if you really want to use this strategy, then priority number one is to minimize the odds of going to zero. That means boring “boomer” businesses are in, and anything hyped on Twitter is out. Assuming you like your money, that is.

The PMCC: know it, but (generally) skip it

I can’t get into all the nuances or possible justifications of the PMCC in a single article. But in the briefest of terms:

• It’s trickier to set up, since you’re managing two options contracts instead of one. Your brokerage will also enforce different permissions and margin requirements.
• When all goes well, it brings in much higher returns on capital than a standard covered call (thanks to far lower capital requirements).
• When all doesn’t go well, it’s more difficult to recover. The share price needs to more than make up for its losses in a limited time frame…and without collecting dividends as you wait.
• Any covered call strategy is best with companies you already want to hold long-term. But with the PMCC, it’s even more important to avoid volatile firms. (That might mean accepting lower short call premiums, too.)

If you like the idea of covered calls, but your capital is too limited to purchase 100 shares of a quality asset, then the PMCC is certainly appealing.

But that doesn’t make it prudent.

Losses hurt even more when funds are that tight. So, ironically, some traders who are the most eager to use the PMCC are actually least able to absorb its risk.

In that situation, I’d focus on earning active income to invest in good ol' shares of great businesses, then simply write standard covered calls (if appropriate) once I’m able.

The PMCC can have a place as a more aggressive strategy for one small chunk of a larger portfolio. Understanding it also puts some important options principles in context. But simpler strategies are better for most people, most of the time.