Selling covered calls can be an attractive way to generate consistent income. However, traditional covered calls require owning 100 shares of a stock, which can be a significant investment. Poor Man's Covered Calls (PMCC) offer an alternative that requires less capital. This article explains how to set up a PMCC, analyze potential win/loss scenarios, and evaluate the risks involved.
Understanding Poor Man's Covered Calls (PMCC)
PMCC allows you to sell calls without owning 100 shares of the underlying stock. It achieves this by utilizing a spread strategy, which involves buying a call option (long call) and selling another call option (short call). The key difference between a typical option spread and a PMCC is that the long and short calls have different expiration dates.
Prerequisites for PMCC Trading
To execute PMCC strategies, you need to have Level 3 option trading enabled in your brokerage account. Without this level, you won't be able to implement the necessary option spreads.
Setting Up a PMCC Properly
Setting up a PMCC correctly is crucial to avoid losses even when the underlying stock price increases. A PMCC consists of two components:
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Long Call: The call option you buy.
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Short Call: The call option you sell.
Long Call Considerations
Two key factors to consider when choosing the long call are:
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Delta: Aim for a delta between 70 and 90. This signifies an in-the-money call, which is generally safer because it has a higher probability of retaining value. A higher delta means the call price will move more closely with the stock price.
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Expiration Date: Choose an expiration date that is 3 months to a year out. Longer expiration dates mean the option loses value more slowly to time decay in the early days.
The ideal long call has a high delta and a distant expiration date, but these calls are typically more expensive. Finding a balance between these factors is important.
Short Call Considerations
When selling the short call, consider the following:
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Delta: Aim for a delta between 10 and 30. This represents an out-of-the-money call.
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Expiration Date: Select an expiration date that is 1 to 4 weeks out. Out-of-the-money options lose time value rapidly as expiration approaches. Selling options with short expiration dates can allow you to collect premiums faster.
Calculating the Delta Gap
The Delta Gap is the difference between the delta of the long call and the delta of the short call. A wider delta gap generally indicates a safer PMCC setup, increasing the probability of profit. A gap of 40 to 50 is suggested as a safe starting point.
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Example:
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Long Call Delta: 90
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Short Call Delta: -10
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Delta Gap: 80
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Win and Loss Scenarios
Analyzing potential win and loss scenarios is crucial for understanding the risk-reward profile of a PMCC.
Potential Profit Scenarios
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Stock Price Rises to the Short Call Strike Price: If the stock price increases to the strike price of the short call, you can buy back the short call at minimal cost and keep the initial premium received. The long call also generates profit due to the increase in the underlying stock price.
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Stock Price Rises Below the Short Call Strike Price: In this scenario, you keep the premium from the short call, and the long call gains value.
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Stock Price Remains Flat: You retain the premium from the short call. While the long call loses some value due to theta decay, the profit from the short call premium can offset these losses.
Potential Loss Scenarios
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Stock Price Drops Significantly: The long call loses value, potentially offsetting the premium received from the short call.
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Stock Price Rises Dramatically: The short call becomes in-the-money, potentially resulting in significant losses. While the long call gains value, it might not fully offset the losses from the short call. The maximum loss can be substantial, depending on the setup.
Managing the Short Call
When the short call expires in the money, consider "rolling up" the call by buying back the existing short call and selling a new short call with a higher strike price and a later expiration date. This can help to offset losses and generate additional premium.
Key Takeaways
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PMCC is a bullish strategy that profits when the underlying stock rises steadily, but not too aggressively.
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Careful setup of the long and short calls, considering delta and expiration dates, is essential.
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Analyzing potential win and loss scenarios is crucial for risk management.
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Managing the short call by rolling it up when necessary can help to optimize profits and mitigate losses.
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Be aware that PMCC is not without risk, and significant losses are possible.