This article explores strategies for managing poor man's covered calls, focusing on adjustments to avoid assignment, understanding the implications of assignment, and how to recover your position.
Understanding the Poor Man's Covered Call
Definition
A poor man's covered call involves owning a longer-term call option (typically a LEAPS option) and selling a shorter-term call option against it. This differs from a traditional covered call where you own 100 shares of the underlying stock.
The Challenge of Assignment
The primary challenge arises when the short call option goes deep in the money. Unlike a covered call where assigned shares are delivered from your holdings, a poor man's covered call requires you to cover the assigned shares since you don't own them outright. This results in a short position of 100 shares per contract assigned, in addition to owning the LEAPS call.
Adjusting a Poor Man's Covered Call Going Deep in the Money
Rolling the Short Call Option
The most straightforward adjustment is to roll the short call option up and out in time. This involves buying back the existing short call and selling a new call option with a higher strike price and a later expiration date.
Example: Apple Trade
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Original position: Long June 2023 115 call, short January 2022 155 call.
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Challenge: Apple's price increased significantly, pushing the short call deep in the money.
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Adjustment: Buy to close the expiring January 2022 150 call and sell to open a January 2022 155 call, collecting a credit in the process.
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The trader tried to roll up to December, but settled for January to avoid debit, which suggests flexibility is needed.
Managing Deeply In-the-Money Positions
Addressing Extreme Situations
When a short call goes very deep in the money, simply rolling it up and out may not be feasible without incurring a significant debit.
Example: Microsoft Trade
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Original position: Long June 2023 235 call, short October 315 call.
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Challenge: Microsoft surged, making the short call deep in the money. Rolling up would have been costly.
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Adjustment:
- Buy to close the existing short call option (November 305 call).
- Sell a further out-of-the-money call (January 310 call)
- Sell a far out-of-the-money put option (January 305 put).
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By selling the put option, the trader generated enough cash to offset the cost of rolling the call option, creating a net credit. This introduces the risk of put assignment.
Monitoring Time Value
Regularly check the time value remaining in the short call option to assess assignment risk. With a non-dividend paying stock, a quick estimate can be gleaned by looking at the corresponding put option price (same strike, same expiration), since the put option's value will mostly be time value premium.
Important Considerations
If you use the put-selling strategy, be aware of the risk of being assigned shares if the underlying stock price declines below the put option's strike price. You may then need to adjust that put option as well.
Handling Assignment
Preventing Assignment
With careful monitoring of time value and timely adjustments, assignment should be rare. It is often more profitable for the option holder to sell the call option rather than exercise it, especially if there is significant time value remaining.
Risks Associated with Dividend-Paying Stocks
Exercise can become more likely as the call option gets very close to expiration or if the stock is about to go ex-dividend and the dividend amount exceeds the time value left in the call option.
Fixing an Assigned Position
- Your broker will typically do nothing with your LEAPS call.
- You will now be short 100 shares per assigned contract.
- To restore your poor man's covered call, buy back the shorted shares (100 shares per contract) and sell a new call option against your LEAPS call. Consider selecting a new call option farther out in time, providing adequate time value premium.
By following these strategies, investors can effectively manage their poor man's covered calls, minimize the risk of assignment, and navigate challenging market conditions.
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