Poor Man’s Covered Call: How to Generate Income with Minimal Capital

The Poor Man's Covered Call (PMCC) is a cost-effective strategy that allows investors to generate income through options without the need to buy 100 shares of stock. By purchasing a long-term LEAPS call option and selling a short-term call against the same stock, investors can collect premiums while benefiting from stock price movements. This strategy is ideal for stable to moderately bullish markets, offering limited risk and lower capital requirements than traditional covered calls. However, it does come with the trade-off of capping potential profits if the stock rises significantly and requires careful management of options with different expiration dates.

Strategy Overview

The “Poor Man's Covered Call” (PMCC) is an options strategy that mimics the income-generation potential of a traditional covered call, but with lower capital requirements. It is often considered a more affordable alternative, making it appealing to smaller investors who may not have the funds to buy 100 shares of a stock. By using long call options (also known as “LEAPS” or Long-Term Equity Anticipation Securities) as a substitute for owning the stock, this strategy allows investors to generate income through the sale of call options while reducing the upfront cost of stock ownership.

1. Buy a Long Call Option (LEAPS): The first step in this strategy is to purchase a long-term call option (a LEAPS contract) on the stock you wish to target. Unlike buying shares of stock, buying a long call requires significantly less capital but gives you the right to benefit from stock price movements up to the expiration of the LEAPS contract.
2. Sell a Short-Term Call Option: Once you own the LEAPS contract, you sell a short-term call option against the same underlying stock. This short call obligates you to sell the stock at the agreed-upon strike price if the option is exercised, but instead of owning the stock outright, you have the LEAPS call option as a substitute.
3. Collect Premiums: Selling the short-term call option, you receive an upfront premium. This premium is the primary income generator in the strategy and is similar to the covered call in terms of cash flow potential.

Outcome Scenarios:

• Short Call Expires Worthless: If the stock price remains below the short call’s strike price at expiration, the call option expires worthless. You retain the premium, and the LEAPS option remains intact for further price movements.
• Short Call Exercised: If the stock’s price rises above the short call’s strike price, the short call may be exercised. You would sell the stock at the strike price, but since you own a LEAPS call option, your profit is still realized from the appreciation of the LEAPS contract.

The Poor Man's Covered Call works best for investors who want to generate income without tying up significant capital in stock ownership. This strategy is particularly useful in flat to slightly bullish markets, where the stock price is not expected to make large, rapid moves upward.

Learn more: The Beginner’s Guide to Options: Mastering the Fundamentals

Practical Example:

Let’s assume stock XYZ is trading at $50, and you decide to enter a Poor Man's Covered Call trade.

• Buy LEAPS Call: You purchase a LEAPS call option with a strike price of $50, expiring in one year, at a cost of $5 per share (or $500 for one contract).
• Sell Short-Term Call: You sell a one-month call option on XYZ with a strike price of $55, collecting a $2 premium per share (or $200 for one contract).

Potential outcomes for the strategy:

• Stock Remains Below $55: If the stock stays below $55 by expiration, the short call expires worthless. You keep the $200 premium and still own the LEAPS call. This setup allows you to potentially benefit from future price increases without the need to sell the stock immediately.
• Stock Rises to $55: If XYZ rises to $55, the short call may be exercised. You would sell the stock at the strike price of $55, locking in a profit from the LEAPS call and the premium. However, you miss out on any upside above $55. Still, you pocket the $200 premium plus any intrinsic value from the LEAPS call.
• Stock Rises Above $55: If XYZ rises above $55, the short call would be exercised, and you would sell at $55, forfeiting the upside beyond that level. However, you still keep the $200 premium and any appreciation from the LEAPS call, resulting in a profit on both the premium and the stock's movement.
• Stock Drops Below $50: If the stock falls below $50, your downside is limited to the $500 paid for the LEAPS call (which is the cost of the option). While the $200 premium provides some cushion, the LEAPS call itself may lose value, but you are not exposed to the full loss of owning 100 shares of the stock.

The Trade-off: The Poor Man's Covered Call strategy offers a more capital-efficient way to generate income than traditional covered calls. However, the risk is that the LEAPS call option can lose value, and while it reduces the need for capital outlay, it does not offer the same degree of control over the underlying stock.

Core Principles

• Capital Efficiency: One of the primary advantages of the PMCC is that it requires less capital than a traditional covered call. You only need to buy a LEAPS call option instead of purchasing 100 shares of stock.
• Limited Risk: The maximum risk is limited to the price of the LEAPS call option. This makes it less risky than purchasing 100 shares of a stock directly, especially if the stock price declines significantly.
• Strike Price Selection: The choice of strike prices for both the LEAPS and the short call determines the balance between income generation and potential upside. Selecting a higher strike for the short call can allow for more upside potential but results in a lower premium.
• Expiration Date: The expiration date for the LEAPS call is usually longer-term (1-2 years), while the short call has a much shorter expiration (typically one month). This provides the investor with the flexibility of long-term exposure to the stock’s movements, while generating more frequent premiums from short-term options.

Learn more: The Beginner’s Guide to Options: Mastering the Fundamentals

Pros and Cons

Pros:

• Lower Capital Requirements: The strategy requires significantly less capital than owning 100 shares of stock, making it accessible to smaller investors.
• Income Generation: Like traditional covered calls, PMCCs generate regular premium income, which can enhance returns.
• Reduced Risk Exposure: You have limited downside risk due to the LEAPS call option, as opposed to owning the stock outright.

Cons:

• Limited Upside: The strategy caps your potential upside if the stock price rises significantly. Once the stock reaches the short call's strike price, your profit is capped.
• Complexity: This strategy can be more complex than a traditional covered call, as it involves managing two different options with different expiration dates and strike prices.
• Option Decay: The LEAPS call option may experience time decay, meaning it could lose value over time even if the stock price doesn’t move much.

Market Conditions: When Is It More Likely to Perform Better?

The Poor Man’s Covered Call is ideal in the following market conditions:

• Stable to Modestly Bullish Markets: It works best when the stock price is expected to remain stable or rise slowly. The strategy profits from the time decay of the short-term call options and any appreciation in the stock.
• Low Volatility: In low-volatility environments, options premiums are lower, but the strategy’s limited risk and ability to generate steady income are still attractive.

It is less effective in:

• High Volatility Markets: In volatile markets, stocks can make large price swings, causing the LEAPS call and short call to behave unpredictably.
• Bearish Markets: The strategy will not protect you from significant downturns, as the LEAPS call will lose value in a falling market.

Click here to check the “OPTIONS PILLARS SERIES” for further insights

Selecting Stocks and Contracts for the Poor Man’s Covered Call

Selecting the right stocks and options is key to maximizing the effectiveness of the PMCC strategy. Focus on stocks that are fundamentally strong, with moderate volatility and a history of steady price movement.

• Strong, Stable Companies: Look for companies with solid earnings and lower risk of sudden, sharp declines.
• Moderate Volatility: Choose stocks with moderate volatility, as these will offer attractive premiums without the risk of extreme price swings.
• Long-Term LEAPS Calls: The LEAPS call should have a strike price that aligns with the investor’s long-term view on the stock’s price.

How Poor Man's Covered Call Fits Into a Passive Income Portfolio

The Poor Man’s Covered Call can serve as an appealing strategy for passive income investors who are interested in generating consistent cash flow without committing the same level of capital required for traditional covered calls. By utilizing long call options instead of owning the underlying stock outright, investors can lower the capital needed while still benefiting from the income potential of selling call options.

Capital Efficiency: The strategy allows you to generate income without the need to buy large quantities of stock, which can be particularly helpful for those with smaller portfolios or limited capital. By purchasing a long call option instead of the underlying stock, you can gain the same exposure to the stock price movements for a fraction of the cost.

Income Generation: Similar to traditional covered calls, the Poor Man’s Covered Call involves selling call options against your long call position. The premiums received from selling the call options provide an additional stream of income, which can complement other passive income sources such as dividends, bonds, and real estate.

Diversification: The strategy can contribute to diversifying your income sources by introducing options trading into your portfolio. This is especially valuable in a portfolio already invested in dividend-paying stocks or bonds, as it brings in a new layer of income potential that may be less correlated to the market movements of your other assets.

Risk Management: The Poor Man’s Covered Call strategy offers a lower-risk alternative compared to owning large amounts of stock while still enabling the investor to benefit from stock price movement. The long call option acts as a proxy for owning the stock, while the risk is limited to the premium paid for the call option (as opposed to the full cost of buying the stock outright).

Flexibility: This strategy can be tailored to match the investor's risk tolerance and income goals. For conservative investors, selecting longer-dated call options with lower strike prices can generate a steady stream of premium income while limiting risk.

Reinvestment Opportunities: Just like traditional covered call writing, the premiums received from the sale of the call options can be reinvested into additional positions, further compounding wealth over time. This can help investors increase their income-generating assets without having to allocate more capital to purchase stock.

Market Adaptability: The Poor Man’s Covered Call can be adjusted based on current market conditions. Whether the market is range-bound, moderately bullish, or stable, you can tailor your strategy to maximize the income potential without being overly exposed to large downside risks. This adaptability makes it an attractive strategy in a variety of market environments.