What are the characteristics of this option strategy?
Poor man’s covered call trades buy a deep-in-the-money call of distant expiration and write an out-of-the-money call of near expiry against it, a long call diagonal spread. The structure expresses a bullish view on the stock without buying the shares, and generates income from the premium collected on the option sold. The long call stands in for the stock at a fraction of the cost, which is where the name comes from, and it also sets the maximum loss: the net debit paid to open the spread.
Is this a bullish, bearish, or neutral strategy?
The Poor Man’s Covered Call Option Strategy is typically a bullish strategy. It is used when a trader has an opinion on the upside direction of the underlying asset. It profits if the underlying rises toward the short strike, and the premium from the short call offsets part of the loss if the stock falls instead. That premium reduces the loss, it does not prevent it, and a large enough decline still costs the whole debit paid for the long call.
Is this a beginner or an advanced option strategy?
The Poor Man’s Covered Call Option Strategy is not suitable for new traders. It is simple to describe but it is a diagonal spread, with two expirations and two strikes to manage, and no stock behind the short call. Handling early assignment on the short leg, rolling it, and judging what the long call is worth when the short expires all take experience.
In what situation will I use this strategy?
The Poor Man’s Covered Call Option Strategy should be used when expecting the underlying asset to make a slight upside move rather than a large directional move. This could be due to a lack of a one-direction upside move of the asset or when you prefer to take profits sooner rather than later.
Where does this strategy typically fall in the range of risk-reward and probability of profit?
The Poor Man’s Covered Call Option Strategy is a defined-risk, moderate-reward trade with a moderate probability of profit. The loss is capped at the net debit paid, which is a real number and often most of the capital committed: $4,463 in the example below. Defined does not mean small. The reward comes from the stock grinding up toward the short strike plus the premium collected on the option sold.
How is this strategy affected by the greeks?
The Poor Man’s Covered Call Option Strategy is often exposed to Delta and Theta risk. Delta measures the sensitivity of the options’ value to changes in the underlying assets’ price, and Theta measures the rate of time decay. The strategy is also exposed to Gamma risk, although to a much lesser extent.
In what volatility regime (i.e., VIX level) would this strategy be optimal?
The Poor Man’s Covered Call Option Strategy can be used in slightly bullish market conditions. High implied volatility raises the premium collected on the short call, but it also raises what you pay for the long-dated call, so a high VIX is not a free gain here. The better setup is a term structure where the near-dated call you sell is priced richer than the far-dated call you buy.
How do I adjust this strategy when the trade goes against me? And how easy or difficult is this strategy to adjust?
Adjusting the Poor Man’s Covered Call Option Strategy, when it goes against you, is relatively straightforward. Depending on the situation, you can either close the position, roll the options to different expiration dates, or move further down your target strike price.
Where does this strategy typically fall in the range of commissions and fees?
This is a two-leg trade, and the short leg is usually rolled every month, so the commissions add up faster than they would on a buy-and-hold stock position. What it saves is capital, not fees: the long call costs a fraction of what 100 shares would.
Is this a good option income strategy?
It can be, because the short call can be rewritten each month while the long call is held, and the loss is capped at the debit paid rather than being open-ended. The limit on that downside is the whole debit, though, so a stock that falls and stays down loses the position outright even after several rounds of collected premium.
How do I know when to exit this strategy?
The appropriate exit strategy for the Poor Man’s Covered Call Option Strategy depends largely on the individual’s goals and risk tolerance. The usual paths are that the short call expires worthless and is rewritten, that it is bought back early once most of its premium has decayed, or that the whole spread is closed by selling the long call and buying back the short one when the stock has run to the short strike and there is little left to gain.
How will market makers respond to this trade being opened?
Market makers generally have no opinion on the trade being opened as they will always try to remain neutral and make a profit from the spread between the bid and ask prices. Therefore, they are unlikely to be taking a view on the strategy’s success.
What is an example (with calculations) of this strategy?
For example, suppose a trader wants to execute the Poor Man’s Covered Call Option Strategy on company MSFT trading at $272. In that case, they will first buy an in-the-money call option of MSFT with a strike price of $230 having an expiration date of 90 days at the market price of $46.80, which costs $4,680, and then sell one call option with a strike price of $290 expiring one month from now for a premium of $2.17 per share, which collects $217. The net debit is $4,463.
That $4,463 is the maximum loss, and it is taken if MSFT is at or below $230 when the long call expires. Measured at the long call’s expiry with the short call already gone, the position breaks even at $274.63, the $230 strike plus the $44.63 net debit per share. If both legs were carried to the same expiry, the maximum profit would be the $60 distance between the strikes less the $44.63 debit, or $15.37 per share, $1,537 on the contract. In practice the short call expires 60 days before the long one, so the trader still holds a call with time value left, and closing there usually returns more than that $1,537 floor. The trade-off is that while the short call is open, MSFT above $290 gains nothing further, because the short leg gives back every dollar the long call makes above that strike.
MarketXLS:
MarketXLS is a great tool for implementing the Poor Man’s Covered Call Option Strategy. It provides powerful analytics, such as options pricing, probability of profit and historical volatility data, which traders can use to accurately assess the risks and rewards of any options trade. Furthermore, MarketXLS’s real-time Option Chain offers streaming option market pricing for over 4,000 stocks and ETFs. This makes finding the optimal options prices for entry and exit strategies much easier.
Here are some templates that you can use to create your own models
Search for all Templates here: https://marketxls.com/templates/
Relevant blogs that you can read to learn more about the topic
Making Sense of the Poverty Trap
Long Call Diagonal Spread – An Advance Option Strategy