Most of us have used, or at least heard about, covered calls
Buy a stock, sell calls against it.
It’s an easy strategy to implement, but the problem, at least for some, comes down to capital. You must have at least 100 shares of stock to sell a call. For some, acquiring 100 shares just isn’t affordable. Others prefer not to up tie up working capital toward 100 or more shares of stock.
It’s a proven long-term strategy, and in my opinion, one that should be incorporated into the portfolios of all investors.
There is an alternative to a covered-call strategy.
And it’s a good one.
In the options world, the strategy is referred to as a poor man’s covered call.
A poor man’s covered call is similar to a traditional covered-call strategy, with one exception in the mechanics. Rather than buying 100 or more shares of stock, an investor simply buys an in-the-money LEAPS call and sells a near-term out-of-the-money call against it.
LEAPS, or long-term equity anticipation securities, are basically options contracts with an expiration date longer than one year. LEAPS are no different than short-term options, but the longer duration offered through a LEAPS contract gives an investor the opportunity for long-term exposure.
Other than reducing the capital required, the reason we purchase LEAPS is to minimize the extrinsic value and theta decay. Basically, a poor man’s covered call is viewed as a diagonal trade with a significantly longer duration.
How I Approach a Poor Man’s Covered Call
First of all, I always start – just like when I use a traditional covered-call strategy – by choosing a stock or ETF that I am comfortable owning for the long term. This is a crucial first step.
Take, for instance, Wal-Mart Stores (NYSE: WMT).
The stock exemplifies the typical low-beta, blue-chip stock that I look for when using a poor man’s covered call strategy.
The next step is to choose an appropriate LEAPS contract to replace buying 100 shares of WMT.
If we were to buy WMT shares at $71.43 per share, our capital requirement would be a minimum of $7,143 plus commissions ($71.43 times 100 shares).
If we look at WMT’s option chain, we will quickly notice that the expiration cycle with the longest duration is the January 2019 cycle, which has roughly 652 days left until expiration.
With the stock trading at $71.43, I prefer to buy a contract that is in the money at least 10%, if not more. For the options geeks out there, I like to buy a LEAPS contract with a delta of around 0.80. Let’s use the January 2019 57.5 strike for our example.
We can buy one options contract, which is equivalent to 100 shares of WMT, for roughly $15.35, if not cheaper. Remember, always use a limit order – never buy at the ask price, which in this case is $15.65.
If we buy the 57.5 strike for $15.35 we are out $1,535, rather than the $7,143 we would spend for 100 shares of WMT. That’s a savings on capital required of 78.5%. Now we have the ability to use the capital saved ($5,608) to work in other ways.
The next step is to sell an out-of-the-money call against our LEAPS contract.
Let’s go with the May 72.5 strike with 43 days left until expiration as our chosen short call strike to sell against our newly purchased LEAPS. 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 again, let’s say we decide to sell the 72.5 strike for roughly $0.96, or $96, against our LEAPS contract.
Our total outlay or risk now stands at $ ($1,535 LEAPS contract minus our premium of $96 from selling the 72.5 calls).
At first, the premium seems small, but on a percentage basis selling the 72.5 call for $96 reaps a return on capital of 6.3% over 43 days. Of course, your upside is limited to the $72.50 with this trade. But hey, is it so bad to lose out on some potential upside to make a 6.2% gain over 43 days?
An alternative way, if you wish to participate on a continued upside move in WMT, is to buy two leaps in the ETF and only sell one call against it. This will increase your deltas and allow half of your LEAPS position to participate in a move past $72.50.
No matter the approach, we can continue to sell calls against our LEAPS contract every month or so to lower the total capital outlay.
Back in early 2016 I added WMT to my Poor Man’s Covered Calls portfolio. At the time the stock was trading for $58.85. As we have already learned from the chart above, the stock now trades for $71.43.
As a result, the return on capital using the poor man’s covered call strategy on WMT is up 66.2% while the stock is higher 21.4%.
By lowering the cost basis of the LEAPS through selling calls, a poor man’s covered call strategy has the opportunity to make a profit in an up, down or sideways market . . . but you must use the strategy correctly.
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Source: Wyatt Investment Research