Covered Calls on a Small Account? PMCC Strategy Explained!

Cover Call Strategy for Small Accounts

This article discusses how to effectively trade the covered call strategy with a small account. It addresses the challenges of stock selection when capital is limited and presents two options: trading covered calls on low-priced stocks versus using a Poor Man's Covered Call (PMCC) on higher-priced stocks.

Stock Selection Challenges with Small Accounts

One of the primary hurdles for small accounts is the limited selection of stocks suitable for covered calls. Many traders with smaller accounts may tend to pick low-priced stocks to trade covered calls, but fundamentally strong stocks often trade at higher prices, making it harder to do covered calls. The low-priced stocks also tend to be more volatile and difficult to make profits on.

The Question

Recently, a viewer asked, "How can I select companies to use with the covered call strategy if I have a small account? I like to choose stocks that are less than or equal to $20. I have a couple of stocks like Riot, INTC, etc. But the premium in those cases is very low." This highlights the core problem: limited choices and low premiums when focusing solely on low-priced stocks.

Two Options for Small Accounts

There are two primary approaches to trading the covered call strategy with a small account.

1. Traditional Covered Call on Low-Priced Stocks: This involves buying 100 shares of a low-priced stock and selling a call option against those shares. The position consists of the 100 shares of stock and the short call option.
2. Poor Man's Covered Call (PMCC) on Higher-Priced Stocks: This uses options to synthetically replicate a covered call, allowing access to higher-priced, fundamentally stronger stocks.

The Poor Man's Covered Call (PMCC)

The PMCC strategy is designed to mimic the covered call strategy using options instead of owning 100 shares of stock. It does not require a trader to be poor. It is comprised of two options:

• A deep in-the-money long call option

• A short call option

Essentially, the deep in-the-money long call replaces the 100 shares of stock in a traditional covered call.

Constructing a PMCC: An NVDA Example

Consider Nvidia (NVDA), a fundamentally strong stock trading around $142. Buying 100 shares for a covered call would cost approximately $14,200, which may be prohibitive for a small account. However, a PMCC can provide similar exposure at a fraction of the cost.

1. The Long Call: Select a long call option with a longer expiration date, around 60 to 120 days to expiration (DTE). This allows for multiple cycles of selling short calls. Avoid short-dated options to minimize theta decay. Aim for a delta of 70 to 80 (or even 90) to minimize the extrinsic value of the option. This also reduces the impact of theta decay on the purchased option. For example, a call with a 71 delta might cost $2,235.

2. The Short Call: Sell a shorter-dated call option, ideally around 45 DTE. The premium received from selling the short call will offset the cost of the long call.

   An edge is created when selling the short call 45 DTE and above.

   Choose a delta around 20 to 30 for the short call. Using the NVDA example, selling a call with a 26 delta might lower the total cost of the PMCC to around $1,960.

This strategy allows you to participate in NVDA's potential upside while only deploying a fraction of the capital required for a traditional covered call.

Which Option is Better?

While both options allow a trader to do covered calls on a small account, the Poor Man's Covered Call tends to be the preffered option.

Option two, the PMCC, is generally preferred because stock selection is critical for the covered call strategy's success. Low-priced stocks may not always appreciate, leading to potential losses. While holding low-priced stocks long-term (Option 1) is possible, fundamentally weaker companies can make profitability challenging.

Riot vs. Nvidia: A Comparative Example

Consider Riot Blockchain (RIOT) as an example of a potentially problematic stock for covered calls. Its price history shows significant volatility and periods of decline. The covered call strategy works best when a stock trends upward. RIOT's income statement reveals inconsistent profitability.

In contrast, Nvidia (NVDA) has demonstrated consistent profitability and revenue growth. Its stock price has generally trended upward, making it a more suitable candidate for a covered call strategy.

Backtesting Results

Backtesting a call debit spread, aiming to simulate the covered call strategy, reveals stark differences between RIOT and NVDA.

• RIOT: The backtest showed a net loss over five years, with a profit rate of only 50%.

• NVDA: The backtest showed a significant profit (over $116,000) over five years. The win rate was significantly higher than RIOT's.

These results demonstrate that a fundamentally strong stock like NVDA offers a higher probability of success with the covered call strategy.

Conclusion

For small accounts, the Poor Man's Covered Call (PMCC) on higher-priced, fundamentally sound stocks (Option 2) is generally the better choice. While it involves options and requires careful management, it provides access to better-quality stocks and a higher probability of profitable trades compared to simply buying 100 shares of a low-priced company (Option 1). While traditional covered calls can have better profitability, those profits are usually outweighed by the larger percentage of capital you would need to devote to that single trade.