The Poor Man's Covered Call strategy is like the Covered Call on steroids. You will get all of the benefits of a Covered Call with a fraction of the risk. You will learn how to generate a covered call without tying up capital buying the stock! Fasten your seat belts...your mind is about to be blown wide open!

The Poorman’s Covered Call is made up entirely of Call options on the same underlying stock (or index). It’s constructed by purchasing a Call LEAP with one strike price and selling (writing) another shorter term expiry Call with a strike price ATM or OTM. The ratio of long calls to short must be 1:1.

The result is a position consisting of a Long Call Leap (lower strike) and a Short Call (higher strike). casual terms to be long a call spread.

Since the long, lower-strike call will cost more than the premium received for the short, higher strike call with the same expiration, a Poorman’s Covered Call will always be established at a net debit. In other words, the amount of cash paid out is more than the cash received.

To establish a Poorman’s Covered Call with XYZ options, an investor might buy 1 XYZ January 60 call for $2.50, and at the same time sell (write) 1 XYZ June 65 call for $0.50. The result is the investor holding 1 XYZ 60/65 Poorman’s Covered Call, or being long 1 XYZ 60/65, at a $2.00 ($2.50 – $0.50) net debit.

The Poorman’s Covered Call is a moderately bullish position. An investor employing this strategy is bullish on the underlying stock (or index), and expects to profit from an increase in its price. However, it’s a moderately bullish position since the investor generally expects the underlying stock (or index) to increase up to or slightly above the short call’s higher strike price by expiration. Above that level, the profit is capped. A more bullish investor might simply buy calls outright.

Since the investor is only moderately bullish on the underlying stock (or index), the cost of buying a call might represent more downside risk than he is willing to take. By selling the higher-strike call and taking in premium, the cost of the long call is in effect reduced. This premium will at least partially offset a loss on the long call if the investor’s bullish forecast is incorrect and the underlying stock (or index) goes down instead. The trade-off for protecting some of the long call’s value in this manner is of course the limited upside profit potential.

The maximum upside profit for a Poorman’s Covered Call is limited to the difference between the calls’ strike prices, less the debit initially paid for the spread plus the remaining value left on the Long LEAP Call. This profit will be seen if the underlying stock (or index) closes at or above the higher strike price of the short call at expiration, no matter how high the underlying stock (or index) increases.

The maximum downside loss for a Poorman’s Covered Call is limited entirely to the net debit initially paid for it. This loss will be seen if the underlying stock (or index) closes at or below the lower strike price of the long call at the Long Call Leap expiration, no matter how low the underlying stock (or index) declines.

Because the Poorman’s Covered Call has two expiries we must consider the fact that the Long Call Leap will have Time Premium left at the short term call expiry. The break-even point (BEP) for a Poorman’s Covered Call at the shorter term expiration is a closing underlying stock price (or index level) equal to the lower strike price of the long call plus the debit paid minus the time premium of the Long Call LEAP.

Of course, if the Short Call Option finishes OTM at expiry this allows you to repeat the process again by selling another Call Option for the following month expiry. The Breakeven point should you get to the longer term expiry of the Long Call will depend on the amount of premium received on Short Calls.

At expiration, if the underlying stock (or index) closes at a point between the breakeven point and either of the two strike prices, either a partial loss or partial profit would be seen. Above the break-even point there would be a partial profit; below the breakeven point there would be a partial loss.

Before expiration, an investor can take a profit or cut a loss by selling the position if it has market value. This involves selling the long call and buying the short call, which will be done at a net credit, and these closing trades may be executed simultaneously in one spread transaction. Profit or loss would simply be the net difference between the debit initially paid for the spread and the credit received at its sale.

The financial impact of a change in volatility depends on whether one or both of the calls are in-the-money and the amount of time until expiration.

For a Poorman’s Covered Call, if the underlying stock (or index) is closer to the lower strike of the long call, losses should increase at a faster rate as time passes. Conversely, if the underlying stock (or index) is closer to the higher strike of the short call, profits should increase at a faster rate with time.

If at expiration the underlying stock (or index) closes at or above the higher (short call) strike price of $65, then the maximum profit would be realized. To realize this profit, an investor has two choices.

With either method, the investor would receive the aggregate difference between the strike prices ($5 difference in strikes x $100 x number of contracts), or $500 total. Maximum profit would be this amount less the $200 debit paid for the spread, or $300 total plus the value left in the Jan $60 Call. Let’s say that amounts to $3.75.

At the Long LEAP expiration, if the underlying stock (or index) closes at or below the lower strike price of $60, both call options would expire with no value, and the net $2.00 debit paid for the spread would be lost.

At expiration, the break-even point for this Poorman’s Covered Call would be a closing underlying stock price (or index level) equal to $60 (lower strike price) + $2.00 (net debit paid) = $62.

BEP = $60 lower strike + $2.00 debit paid = $62

Some Poorman’s Covered Calls can be considered more bullish than others. The degree of bullishness depends primarily on the strike price of the short call, which determines how high the underlying stock (or index) needs to increase for maximum profit to be realized at expiration.

Assignment on any Equity option or American-style index option can, by contract terms, occur at any time before expiration, although this generally occurs when the option is in-the-money.

For an equity call option, early assignment usually occurs under specific circumstances; such as when underlying shareholders are about to be paid a dividend. Assignment at that time might be expected when the dividend amount is greater than the time value in the call’s premium, and notice of assignment may be received as late as the ex-dividend date. If a Poorman’s Covered Call holder is assigned early on the short call, then he may exercise his long call and buy shares to fulfill the assignment obligation. In this case, maximum profit on the Poorman’s Covered Call would be realized.

If early assignment is received on the short call of a Poorman’s Covered Call, the cash settlement procedure for index options will create a debit in the investor’s brokerage account equal to the cash settlement amount. This cash amount is determined at the end of the day the long call is exercised by its owner. After receiving assignment notification, usually the next business day, when the investor exercises his long call the cash settlement amount credited to his account will be determined at the end of that day. There is a full day’s market risk if the long option is not sold during the trading day assignment is received.

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