Poor Man's Covered Call Explained - Full Example
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Poor Man's Covered Call Explained - Full Example |
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This Video Uploaded At 21-05-2021 15:00:00 |
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Poor Man Covered Call
A "Poor Manβs Covered Call" is a Long Call Diagonal Debit Spread that is used to replicate a Covered Call position. The strategy gets its name from the reduced risk and capital requirement relative to a standard covered call.
Directional Assumption: Bullish
Setup:
- Buy an in-the-money (ITM) call option in a longer-term expiration cycle
- Sell an out-of-the-money (OTM) call option in a near-term expiration cycle
The trade will be entered for a debit. Itβs important that the debit paid is no more than 75% of the width of the strikes.
Example:
Stock at $100
Purchase (Expiration 2) 90 call for $15
Sell (Expiration 1) 110 call for $5
Net debit = $10.00 on a 20-point-wide long call diagonal spread
Ideal Implied Volatility Environment: Low
Max Profit: The exact maximum profit potential cannot be calculated due to the differing expiration cycles used. However, the profit potential can be estimated with the following formula:
Width of call strikes - net debit paid
How to Calculate Breakeven(s): The exact break-even cannot be calculated due to the differing expiration cycles used in the trade. As a rough estimate, the break-even area can be approximated with the following formula:
Long call strike price + net debit paid
Trade approach:
A Poor Manβs Covered Call is a fantastic alternative to trading a covered call. In smaller accounts, this position can be used to replicate a covered call position with much less capital and much less risk than an actual covered call.
The setup of a poor manβs covered call is very important. If we have a bad setup, we can actually set ourselves up to lose money if the trade moves in our direction too fast. To ensure we have a good setup, we check the extrinsic value of our longer dated ITM option. Once we figure that value, we ensure that the near term option we sell is equal to or greater than that amount. The deeper ITM our long option is, the easier this setup is to obtain. We also ensure that the total debit paid is not more than 75% of the width of the strikes.
We never route poor manβs covered calls in volatility instruments. Each expiration acts as its own underlying, so our max loss is not defined.
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