The Poor Man’s Covered Call (PMCC) Explained
The poor man’s covered call strategy, also referred to with the abbreviation PMCC, is a variation of the basic covered call strategy. It’s the same concept, you have a long position and then you sell calls against it to generate an income. The difference is that the poor man’s covered call strategy lets you do the same thing with less capital. This strategy is one of the most popular theta strategies since you can get incredible returns with a small amount of capital.
When you use the poor man’s covered call strategy, you purchase a LEAPS instead of 100 shares of a stock. Buying the LEAPS lets you mimic a 100 share position with less capital. In most cases, the LEAPS will cost you half of what it would’ve costed to purchase 100 shares.
I’m going to give you a step-by-step guide on how I set up my poor man’s covered calls because it can be a bit complicated. Let’s get into it!
Setting Up Your Poor Man’s Covered Call (PMCC)
The first thing you’re going to want to do is find a stock that you like. In my experience, the best stocks for this strategy have an implied volatility above 50%. If you want to know how I find stocks for this strategy, check out my post for finding the best stocks for the wheel strategy. The same steps I use to find those stocks apply here.
After you find the stock you want to use this strategy on, head on over to your options chain to pick a LEAPS.
Finding the Right LEAPS for your PMCC
If you aren’t familiar with what a LEAPS is, it’s a Long-term Equity Anticipation Security. Basically, it’s a long-dated option that mimics a stock closely. Most investors buy LEAPS that expire at least one year from the time of purchase. I prefer grabbing LEAPS that expire in 2 years. That gives me two years to generate an income off of my position.
To keep your PMCC as profitable as possible, you’re going to want to pick a LEAPS that has as little extrinsic value as possible. The LEAPS with the least extrinsic value will be fairly deep in-the-money. As I’m sure you already know, deep in-the-money options are almost 100% intrinsic value. You want this for two reasons:
- Deep in-the-money options don’t lose much value due to Theta (time decay).
- Deep in-the-money options have a Delta close to 1.00.
Now that we have that out of the way, let me give you an example of what I consider to be a good LEAPS to buy for your PMCC.
Example of Finding a LEAPS for your PMCC
I’m going to use TLRY (Tilray Inc.) for this example. TLRY is trading at 26.29. If you were to buy 100 shares of TLRY at this price, it would cost you $2,629. But you don’t want to put $2,629 into TLRY, so you are going to use a LEAPS to get the same exposure.
Remember, you want a LEAPS that’s deep in-the-money. In my experience, options that are at least 50% in-the-money have the least extrinsic value and aren’t too expensive.
You can come up with the ideal strike to use by multiplying the stock price by 50%. TLRY is trading at 26.29, so you’d do the following calculation:
26.29 * 0.50 = 13.14
Now you know that you will need to look at a strike of 13 or less.
Remember, I like my LEAPS to have an expiration of two years, so I’m going to be looking at the January 2023 series.
As you can see, the 10 strike is more than 50% in-the-money and the ask is only 19.55. If you chose to use this as your LEAPS, you’d only pay $1,955 for your position. That’s $674 cheaper than buying 100 share!
Before you purchase the LEAPS, you need to make sure it mimics 100 shares of TLRY and doesn’t have too much extrinsic value. Now you need to open the details of the 10 strike call and look at the Greeks.
The first thing you should look at is the open interest. Since the open interest is 4,679, you know the option is fairly liquid. You should be able to get in and out of your position with ease.
The second thing to look at is the Delta. Remember, a 1.00 Delta means that the option moves 1.00 for every 1.00 the stock moves. The Delta for this 10 strike call is 0.92. This is good, your LEAPS will increase in value by 0.92 for every 1.00 TLRY increases.
The third thing to look at is the Theta. The Theta in this example is 0.003. Your LEAPS will only lose 0.003 per day.
Since this 10 strike call meets all of your requirements, you can purchase it. Now that you have your LEAPS, it’s time to figure out which call you should sell.
Figuring Out the Breakeven Point of your PMCC
If you thought figuring out the strike to get for your LEAPS was complicated, you’re not going to like this either… You have to be very careful when picking the call to sell. It’s very easy to pick the wrong call and end up with a loss.
To avoid an unnecessary loss, you need to know your breakeven point. Knowing your breakeven point is the most important part of this strategy! So how do you figure out your breakeven point? You add the premium you paid for the contract to the strike price.
Example of Calculating your Breakeven Point
I’ll show you how to calculate your breakeven point by using the TLRY example from above.
You bought the 10 strike call for 19.55. To find your breakeven point, you will add the premium you paid for the contract to the strike price. The equation looks like this:
19.55 + 10 = 29.55
Your breakeven point is 29.55. Now that you know this, you can look for a call to sell.
Finding a Call to Sell for your PMCC
This part is the easiest. You just need to make sure that you sell a call that has a strike greater than your breakeven point.
Using our TLRY example- you’d have to sell a call with a strike of at least 30. If you sold a strike less than 30, you run the risk of an unnecessary loss. Let’s see how much you’d collect by selling a 30 strike call with 24 days until expiration:
As you can see, the 30 strike call is trading for about 1.88. When you sell it, you will be collecting $188. This is 9.6% return in only 24 days! If you were able to keep this up for the entire 2 years of the LEAPS, you’d generate $2,256. That’s a 115% return!
Remember, those numbers only reflect what you will be making from the premium you collect. You’ll also be making money as TLRY increases in price. Therefore, it’s likely that your return would be much greater than 115%.
Of course, this is an example where everything works out perfectly. This is the stock market we are talking about here… things don’t always go according to plan. You might not always find winners like this TLRY example, but that all depends on the stock you choose for this strategy and overall market conditions.
What Happens to your PMCC When your Short Call goes In-The-Money
When you sell a call, you are giving someone the right to buy 100 shares of a stock from you. They can only exercise their option if it goes in-the-money. Options can be exercised as soon as they go in-the-money, but most people won’t exercise them until the expiration date. If the person exercises their option, you have to the sell them 100 shares.
You might be wondering how this applies to you since you don’t have 100 shares of the stock. Well here’s how- when you sell a call against an option and it gets exercised, the broker will exercise your LEAPS and you will now have 100 shares to sell to the buyer.
When your LEAPS gets exercised by the broker, you lose the premium you paid for it. Your profit/loss is calculated as follows:
((strike of the short call) – (strike of the LEAPS) – (premium paid for the LEAPS) + (premium received for the short call)) * 100
Example of Having Your Short Call Exercised
Let’s say you sold that 30 strike call on TLRY and collected the $188 in premium. On the expiration date, TLRY is trading at 31. You know that your short call will be exercised and you will lose your LEAPS. Let’s look at what profit this leaves you with:
((30) – (10) – (19.55) + (1.88)) * 100 = $233
Your total profit for the 24 day holding period would be $233, a 11.9% return on your investment. You’ll now have $2,188 to put into another PMCC if you’d like.
How is a Poor Man’s Covered Call (PMCC) Better Than a Traditional Covered Call
You already saw that using a poor man’s covered call is better than a traditional covered call because it requires less capital upfront, but why is this better?
It’s better because now you can either double down on positions or put the excess cash into another investment. In simple terms, it let’s you use more leverage to maximize your potential returns.
To show you the different in the rate of return, let’s look at the TLRY example one last time:
In the TLRY example, selling a 30 strike call with 24 days until expiration would give you a 9.6% return on your PMCC. If you used a traditional covered call, you’d only get a 7.1% return. Over the course of two years, you’d be missing out on 60% in gains.
Final Thoughts
In my experience, the poor man’s covered call strategy totally crushed the traditional covered calls strategy. I’ve significantly increased my ROI since I started using more poor man’s covered calls in my portfolio. In many cases, my ROI doubled compared to what it would have been with traditional covered calls.
Should you use poor man’s covered calls? Well that’s entirely up to you and your risk tolerance. I only use poor man’s covered calls on stocks that I’m confident will keep growing. Why? Well since your returns are magnified when the stock goes up, that means your losses will be magnified when the stock goes down. On top of that, selling options is one of the best forms of passive income! Nothing can beat that!
Did you learn anything useful from this post? Will you be using the poor man’s covered call strategy? Have you used it before? What are your thoughts? Make sure to let me know!
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