Income Generation with the Poor Man's Covered Call (PMCC) Strategy
This article outlines a unique approach to the Poor Man's Covered Call (PMCC) strategy, focused on generating consistent income rather than primarily aiming for capital appreciation. This variation, referred to as the "Income PMCC," prioritizes weekly cash flow by leveraging extrinsic value.
Understanding the Insurance Company Analogy
Consider your trading activity as running your own insurance company. As a premium seller, you provide insurance by selling options contracts in exchange for premium payments. The goal is to consistently collect enough premium to cover potential claims. This necessitates strong underwriting skills to assess risk and determine appropriate premium levels.
The Importance of Underwriting and Risk Management
Effective underwriting is crucial. Avoid underestimating risk, as unexpected events ("hurricanes") can lead to losses exceeding collected premiums. While losses are inevitable in trading, consistent premium collection, like an insurance company, builds a buffer to absorb occasional large losses.
Traditional PMCC vs. Income PMCC
The traditional PMCC typically involves buying a LEAP option (long-term equity anticipation security) or using a synthetic strategy alongside selling covered calls. The aim is to capture appreciation in the underlying asset and generate income. However, this strategy is generally more suitable for investment accounts. In contrast, the Income PMCC focuses solely on generating weekly cash flow within a trading account, a smaller portion of overall wealth geared for higher-risk, higher-reward activities.
Core Principles of the Income PMCC
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Focus on Extrinsic Value: The primary objective is to capture the extrinsic value of the covered calls over time.
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Income, Not Appreciation: Unlike traditional PMCC strategies, the Income PMCC prioritizes cash flow, even if it means capping potential upside.
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Embrace Fluctuations: Losses on covered calls are expected. The key is that consistently collecting extrinsic value outweighs these losses over the long term.
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Time Horizon: Consider "extrinsic value" and "over time" as your mantras for this strategy.
Entry Criteria
The following criteria should be considered when implementing this trade:
- Uptrending Weekly Chart: Identify assets with a clear uptrend on a weekly timeframe, showing higher highs and higher lows.
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RSI and Reversals:
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An ideal entry point includes Relative Strength Index (RSI) values under 50.
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Alternatively, look for assets reversing or bouncing off oversold or support levels. Examples include an RSI moving from under 30 into the 40s or price action near the lower Bollinger Bands.
- Pullbacks: Look for pullbacks to key moving averages, such as the 50-day, 100-day, or even the 200-day EMA on the daily chart.
- High-Quality Assets: Focus on established, stable growth stocks or assets.
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Option Selection
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Long Calls (LEAP): Buy long call options with 180 to 365+ days to expiration (DTE). This can extend to 400-600+ days during opportune moments, such as significant dips.
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Short Calls (Covered): Sell near-the-money (ATM) call options with approximately 7 DTE for weekly income. Flexibility is allowed when selecting call options. 14 to 30 DTE calls can be implemented if vacation is coming or you are unable to manage this trade. You can also go slightly in the money (ITM) or out of the money (OTM), depending on market conditions and the desired premium.
Trade Examples: SPY, Tesla, Berkshire Hathaway, and MicroStrategy
The presenter reviews several potential candidates for the strategy, outlining how to analyze their charts and option chains. For example, SPY did not meet entry criteria because of RSI value. Tesla, Berkshire Hathaway, and MicroStrategy were viable, but with varying levels of risk.
Management
The following guidelines should be considered when managing this trade:
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Close Short Calls: Aim to close short calls when 80-90% of the extrinsic value has been realized, or allow them to expire if not threatened. Be prepared to close positions to avoid assignment, particularly near expiration.
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Early Profit Taking: Consider closing the covered call early if 50% of the profit is achieved in 50% of the time.
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Loss Mitigation: Consider closing the entire trade if the loss on the long calls, minus the gains on the covered calls, exceeds 30%.
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Overall Trade Profit: Take profits on the entire trade if 50% (or more) gains are achieved, depending on market conditions and remaining time to expiration.
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LEAP Expiration: Close the entire trade when the LEAP options are within 60 days of expiration to avoid time decay.
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Underlying Outlook: Close the entire trade if the outlook for the underlying asset changes significantly due to fundamental, economic, or technical factors.
Final Thoughts
The Income PMCC strategy is not foolproof and involves accepting losses on covered calls. The consistent collection of extrinsic value over time is the key to profitability. Analyze the overall performance of the trade, considering both call premiums and underlying asset appreciation, rather than focusing solely on individual weekly results.
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