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Understanding Poor Man’s Covered Call When Investing

When Investing

Diversifying your money by utilizing options can provide you with several strategies to manage risk and accumulate wealth. One of these strategies, a covered call, can assist in generating income. However, using this method may be more expensive than you’d like if you have a large capital outlay to buy a stock. Fortunately, there’s an alternative strategy you might want to utilize.

Using a Less Expensive Strategy

If you own a stock and want to generate extra income, you can try using a covered call strategy. This technique involves selling call options when you already have shares in your possession. While it’s one of the safest option trades you can make, it may be expensive for some individuals. If you’re unable to spend the money required by this strategy, you can always use a poor man’s covered call to make the trade more affordable. This strategy doesn’t require you to buy a stock. Instead, you can purchase a LEAPS contract with an expiration date longer than one year. Doing so allows you to spend less money on the trade and still make a decent profit.

How It Works

According to Tastytrade, “the setup of a poor man’s covered call is very important. If we have a bad setup, we can actually set ourselves up to lose money if the trade moves in our direction too fast.” Knowing this makes it essential to understand how to set the trade up properly.

Using this technique involves two main steps, which include the following:

– Buying an in the money LEAPS call

– Selling an out of the money call with a near-term expiration date

Understanding the Strategy May Be More Straightforward by Using an Example:

Step 1. Begin the trade by finding a stock with low volatility. Choosing one with a beta less than 1 should be ideal as you want to trade an option that has a lot less volatility than the market.

Step 2. Use a limit order to purchase one deep in the money call option with a later expiration date that’s associated with the stock you chose in the first step. It’s best if you buy a contract that’s at least 10 percent in the money. If the stock’s current value is $62, you might choose a strike price of $50. This will cost less than the $6200 price tag you’d pay by buying 100 shares of stock.

Step 3. Choose an out of the money strike price, such as $65, and sell a LEAPS contract against it.

Each month, you should continue to sell call options against the LEAPS contract you own, which will reduce the total capital outlay. It’s important to keep an eye on your LEAPS contract’s expiration date as you will want to sell it as it nears expiration. You can use the proceeds to continue the strategy.

If you follow this method, it should help you generate extra income without having to make a significant capital outlay initially. This can help if you have limited capital or would like to use a portion of your money for other investment strategies.

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