Unlocking Big Returns with Minimal Investment – Modest Money

Are you looking for a way to dip your toes into options trading without diving headfirst into the deep end of capital requirements? Well, you might just be in the right place!

Today, we’re going to unpack a strategy known in the trading world as the “poor man’s covered call.” Don’t let the name fool you; this strategy can be a smart move for anyone looking to stretch their investment dollars further. It’s tailor-made for those who wish to leverage the benefits of covered calls but are looking for a more budget-friendly entry point.

If you’re not yet familiar with the basics of options, I highly recommend pausing here and checking out my article on option trading basics. It’ll give you the groundwork needed to make the most out of this discussion.

Once you’re up to speed, come back, and let’s dive into how the poor man’s covered call might just be the financial strategy you’ve been searching for to enhance your portfolio without breaking the bank.

Stick around as we explore the ins and outs of this intriguing approach, and you might find a new tool to add to your trading toolkit! If you prefer visual learning, check out this video:

Key Takeaways

• The Poor Man’s Covered Call strategy is a budget-friendly approach to options trading that allows for premium income generation and potential capital appreciation with a significantly lower initial investment compared to traditional covered calls.
• This strategy uses in-the-money long call options to simulate stock ownership, combined with selling short call options to generate income, effectively managing risk while providing upside potential.
• Ideal for moderately bullish market conditions, this strategy thrives when stock prices are expected to rise modestly, allowing investors to profit up to the strike price of the short call while also collecting premiums.
• The Poor Man’s Covered Call is an excellent tool for investors looking to diversify their strategies and maximize returns without committing large amounts of capital.

What is a Poor Man’s Covered Call?

The “Poor Man’s Covered Call” (PMCC) is a variation of the classic covered call options strategy, but it requires much less capital to execute. Instead of holding the actual stock to cover the short call, the Poor Man’s Covered Call uses a long call option, specifically an in-the-money option in a longer-term expiration cycle. This setup essentially replaces the need to own shares of the stock, making it a more budget-friendly strategy for traders.

The Poor Man’s Covered Call operates like a long call diagonal debit spread. It mimics the payoff of a traditional covered call by utilizing a long-term call option to cover the risk associated with the short call. This method lowers the initial investment required significantly compared to buying shares outright.

As a result, traders can participate in a covered call strategy with less financial outlay, maintaining exposure to the stock’s upside potential while also collecting option premiums, which can enhance overall returns.

By choosing strike prices wisely, selecting a long call with a strike price below the current price of the stock, you can set up a position that captures potential price increases and earns premium income, similar to a traditional covered call.

The Poor Man’s Covered Call offers a cost-effective way to benefit from stock price movements and option premiums with a reduced financial commitment.

How Does A Poor Man’s Covered Call Work: A Step-By-Step Guide

Here’s a simple step-by-step guide on how to set up and execute the poor man’s covered call strategy:

1. Choose the Right Broker: Start by selecting a broker that supports options trading with the features you need. Both TradingView and Robinhood offer platforms that are suitable for options trading. TradingView is known for its active trading community and sophisticated tools, while Robinhood is favored for its user-friendly interface and zero-commission structure. To decide which broker fits your trading style best, read my TradeStation review and Robinhood review.
2. Select a Long Call Option: The first step in setting up a PMCC is to buy a long call option that is in-the-money. This means choosing a call option with a strike price that is below the current market price of the stock. It’s recommended to select an option with a longer expiration date, typically several months to a year out, to give the stock ample time to move and to reduce the impact of time decay on the option’s value.
3. Sell a Short Call Option: Once you have your long call in place, the next step is to sell a short call option at a higher strike price but with a closer expiration date. This option should ideally be out of the money. The short call premium helps offset the cost of the long call, and this setup creates an income stream similar to a traditional covered call.
4. Calculate Your Risk and Potential Reward: Before finalizing the trade, evaluate the potential upside and risk. Your maximum profit is capped at the strike price of the short call option, minus the strike price of the long call, plus the net premium received (the premium received from the short call minus the premium paid for the long call).
5. Monitor Your Positions: Keep an eye on both positions as market conditions change. If the stock price rises towards the strike price of the short call, you may need to decide whether to buy back the short call to avoid assignment or let it expire and sell the shares if exercised. A good options signal provider, like OptionStrat, can make this process much easier. Check out my OptionStrat review to see if it is worth adding to your trading arsenal.
6. Adjust as Necessary: Depending on market movements and your investment outlook, you might choose to roll out the short call to a later date or adjust the strike prices to better suit the evolving market conditions.
7. Closing the Position: You can close your PMCC by simultaneously selling the long call and buying back the short call. This can be done to lock in profits, cut losses, or if you decide to change your investment strategy.

How To Calculate Profit and Loss in A Poor Man’s Covered Call

The process of calculating profit and loss in a poor man’s covered call is straightforward. Here is the formula:

Max Profit= width of call strikes – trade costs

Or put more simply:

Max Profit= (Short Call Strike Price – Long Call Strike Price) – Net Premium

When to Use A Poor Man’s Covered Call

This strategy is particularly well-suited for investors who seek to generate income and possibly enjoy some capital appreciation, without the significant capital outlay required for a traditional covered call. Here are some ideal market conditions for implementing the poor man’s covered call:

1. Moderately Bullish Market: The PMCC is perfect when you anticipate modest upward movement in the stock price. Since this strategy involves selling an out-of-the-money call, it thrives when the stock price increases but not beyond the strike price of the short call. This allows you to benefit from the stock price rise up to the strike price while keeping the premium received from selling the call.
2. Flat to Slightly Rising Stocks: If you have a bullish outlook on a stock but don’t expect dramatic price increases, a PMCC is advantageous. The strategy lets you capitalize on slight upward movements and time decay, as the value of the short call option you sold declines as it approaches expiration, assuming the stock price does not exceed the strike price of the short call.
3. Stocks with Predictable Price Movements: Stocks that have less volatile and more predictable price movements are ideal candidates for PMCCs. These stocks present less risk of the short call being exercised, allowing you to manage the position more easily and with less risk of needing to cover a call assignment unexpectedly. Check out my article on what is a good implied volatility for options if you aren’t already proficient in this area.
4. Cost-Efficient Strategy for Diversification: For individual investors looking to diversify their options trading strategies without significant capital, the PMCC offers a cost-effective alternative. It requires less capital compared to owning the stock outright and still allows participation in potential equity gains and income generation from premium receipts.

Poor Man’s Covered Call Profit And Loss Scenarios

Here are simple to understand winning, losing, and break even scenarios using the poor man’s covered call:

• Profitable Scenario: Achieved when the stock price is at or above the strike price of the short call at its expiration. The profit is the difference between the strike prices minus the net premium paid.
• Break-Even Scenario: This occurs when the gains from the stock price movement equal the net premium paid. It can be calculated as the long call strike price plus the net premium paid.
• Losing Scenario: While the PMCC limits some downside risk because you do not own the stock directly, the maximum loss occurs if the stock price falls significantly, rendering both options worthless, equal to the net premium paid.

Poor Man’s Covered Call: My Final Thoughts

The Poor Man’s Covered Call strategy offers a practical approach to options trading, especially appealing for those aiming to maximize their investment potential without a significant initial outlay.

By strategically selecting strike prices below the current stock price for the long call and above it for the short call, this approach aligns with moderately bullish market conditions, where the stock is expected to rise but not dramatically. It’s an excellent strategy for managing a stock position with minimized risk and controlled potential for profit.

The initial cost is reduced compared to traditional stock trading, and the setup maximizes profit potential by allowing investors to benefit from time decay on the shorter expiration of the short calls.

For individual investors, this strategy is particularly beneficial. It not only offers an income-generating opportunity but also keeps additional costs, such as transaction costs, relatively low.

This makes the Poor Man’s Covered Call a valuable part of a diversified investment strategy, especially in stable or slightly bullish markets where the stock price is expected to rise but remain below the short call’s strike price at expiration.

If you’re curious to explore more such strategies that balance risk and reward effectively, consider diving into my article on low-risk options strategies. Additionally, for those looking to deepen their understanding of options, I recommend checking out my Motley Fool’s Options review. Becoming a successful options trader requires continually learning.