Smart Money: The Poor Man’s Covered Call

In my most recent blog post, I talked about shorting/selling a call, aka a covered call. This technique is used as a way to reduce cost basis against shares held, and can also be used as an income generation technique for larger accounts.

However, not everyone has a large account (I definitely don’t). So what are some alternatives to going long on 100 shares and selling a call against it?

One of the choices that we have is the Poor Man’s Covered Call. This is a trade that is less capital intensive and carries less risk than the covered call. This trade is more technically known as a long call diagonal debit spread, but Poor Man’s is a lot more fun to say.

It involves buying an ITM call in a longer term expiration cycle (normally about 70 deltas out), and then selling a nearer term OTM call (30 delta). The goal is to have the ITM call replicate the long shares of stock that we see on the covered call, and for the OTM call to provide some premium.

derivatives-10-728

Image via Slideshare 

When trading a PMCC, we look for lower volatility stocks. This is GOOD. Most of the time, options trading requires a bit of a volatility, in order to capture the premium crush when the volatility of the stock does eventually decline.

Most of the trades I execute (Iron Condor, Vertical Spreads) are trades that thrive in high volatility environments, so the PMCC is a good plan to have when volatility is low (like it is right now – I’m looking at you, VIX).

The trade itself is bullish, which lends itself well to balancing out the deltas in a portfolio. If you’re trying to remain even in the market with a delta neutral portfolio (some trades bullish, some trades bearish) this trade can help generate some positive deltas. Also, if you’re bullish on a low IV stock, this is a good trade to place. (If this delta talk made no sense, check out this blog and be on the lookout for my Greek series in the next few weeks)

option-greeks

Image via Trading Campus

(Note: Rho is actually a measure of change in option price when interest rates move)

The most difficult thing with the Poor Man’s Covered Call is finding a happy place with the net debit. We have to pay for this trade (one of the downsides). One of the goals is not pay more than 75% of the width of the strikes. So if I am selling a 110 / 120 long diagonal call spread, I don’t want to pay more than $7.5 [(120 – 110) x 0.75]

When we go farther out in expiration cycles, such as we do with the long ITM call, we usually have to pay more for the option.

This is because these longer termed options have more time to make more money. So if I sold a 110 call at the 72 day expiration, I would have more time to be right on my prediction than if I sold the 110 call at the 44 day expiration. This is measured by one of the Greeks known as “vega” which tracks the change that implied volatility has on the price of an option.

As we go further out in time, implied volatility increases.

It’s kind of like looking into your own future. For example, I know what my lunch will be tomorrow – sandwich, apple, and a granola bar. But 5 years from now? I have no idea what my lunch might be (although, honestly, it will probably be the same). 5 years into the future carries a much higher implied volatility for my daily structure than my tomorrow does.

But vega also represents a certain portion of risk. Because it’s so far out into the future, the option price can vary pretty wildly. It has more time to be right, but it also has more time to be wrong.

Think about trying to plan a wedding that will happen 3 years from now – that’s a pretty risky proposition! No one really knows where they will be on that date, the weather might be crazy, and a lot can change for the couple involved over that time frame.

That’s vega. The more time, the more sensitive the option is to a change in implied volatility.

That’s why our long ITM call in the PMCC is more expensive than our short OTM call.

Also, the further we get ITM (the farther we get from the stock price) the more expensive the call tends to be. For example, the 110 call would be a lot cheaper on a 115 stock than a 105 call would be.

When we sell a call, we are using a bullish strategy. By selling the 110, we are making the prediction (essentially) that we expect the price of that stock to rise past the strike, in this case, 115. When we buy it against the 105, we are still making the prediction that the stock is going to rise above 115.

We just have to retain the debit we paid on the stock. So if I paid $8 for the ITM 110 call against the 115 stock price (Intrinsic Value $5 / Extrinsic Value $3) and if I sold the OTM 120 call at $2 extrinsic value, I would need the stock to rise $1 to make money.

One. Dollar.

This is calculated by taking the extrinsic value from the 110 call ($3) and subtracting that from the credit received from the 120 call ($2)

I would need the stock to rise to 122 (strike + debit) before I started seeing any reward. However, if I sold it at the 115 stock price at $6, I would need the stock to rise to $121 (strike + debit) to make some money.

So we have to find a balance between going too deep ITM and too far out in time for our Poor Man’s Covered Call.

So let’s see this in the real world.

The Q’s are actually pretty low volatility right now, which is pretty nice for this trade. Being bullish on the Q’s is pretty easy, as they are an ETF that tracks the tech stocks (your Apple, Amazon, Microsoft, Facebook, Google etc). The tech stocks always tend to trend upwards, given our current tech-consumed environment.

The Q’s are current trading at $174 and have an 30-day IV percentile of 11, contrasted against the VIX of 12.13.

QQQ IV

Historical IV for QQQ via MarketChameleon

After comparing the debit paid and the width of the strikes, I am trading the 168 / 178 long call diagonal spread for a $8.19 debit. The 168 call is trading in the 72 day expiration range at $10.25 (with an intrinsic value of $6 and extrinsic value of $4.25), whereas the 178 call is trading at the 44 day expiration range at $2.06 (no intrinsic value and extrinsic value of $2.06).

  • Intrinsic value = Stock Price – Strike Price
  • Extrinsic value / time value = Debit Paid – Intrinsic Value

There are many moving pieces to this trade. Time, intrinsic value, extrinsic value, and volatility. Sugar, spice, and everything nice.

We can make money on this trade if it goes up or stays about the same. It’s difficult to calculate probability of profit because we are working in two different time frames. We can estimate it by taking the difference between the strikes and subtracting the debit paid:

  • [178 – 168] – $8.19 = $1.81

Likewise, the breakeven point is also difficult to calculate. We can get an estimation by taking the long call strike (168) and adding the debit paid ($8.19) to get 176.19

qqqq

So in order to get close to making the $181 in potential profit, we have to first have the stock break through the 176 barrier. This should be pretty probable, given the fact that the stock is already at $174.

The poor man’s covered call is a pretty simple way to replicate the covered call, and still get some pretty decent profits. Extreme couponing, but for the smaller wallet.

It thrives in low volatility, which is all too commonplace recently, and also allows for a bullish play. It does require a debit, and not a credit, which is a downside. However, it is a GREAT way to replicate one of the most common option trades used on the market – and a great way to generate some income!

The next blog will discuss the Greeks, such as vega, in more detail. (Rush Delta Vega Theta!)

Also, my pictures will get better for options visualization. I promise.

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