Poor Man's Covered Call Option Strategy

In summary:

• A Poor Man’s Covered Call (PMCC) is an options strategy that mimics the traditional covered call while requiring less capital.
• It substitutes the stock holding with a long-dated, deep In-The-Money (ITM) call option.
• The strategy involves buying a long-term ITM call and selling a short-term Out-of-The-Money (OTM) call.
• PMCC is suitable for investors with limited capital but requires careful management to mitigate risks.
• This guide explains the PMCC setup, breakeven calculation, management techniques, and compares it with the standard covered call.

Options trading can seem daunting, especially for beginners in the Indian financial market. However, strategies like the Poor Man’s Covered Call (PMCC) offer an accessible way to participate without requiring substantial capital. The PMCC strategy is a variation of the traditional covered call, designed to make options trading more affordable while providing opportunities for generating income.

In this article, we will explore the mechanics of the PMCC strategy, its setup, advantages, disadvantages, and how it compares to the standard covered call. We will also provide a practical example using Nifty stocks to help you understand its application in the Indian financial market.

A Poor Man’s Covered Call (PMCC) is an options trading strategy that aims to replicate the benefits of a traditional covered call but with reduced capital requirements. Instead of purchasing the underlying stock, traders buy a long-term deep In-The-Money (ITM) call option. This ITM call acts as a substitute for owning the stock, while a shorter-term Out-of-The-Money (OTM) call is sold to generate income.

This strategy is popular among traders who wish to participate in options trading with limited funds. It allows for potential profit through premium collection and capital appreciation without requiring the full capital needed to buy the underlying stock.

The PMCC strategy works by leveraging options contracts to mimic the benefits of holding a stock while reducing upfront capital requirements. Here is how it operates:

1. Long-dated ITM call: The trader buys a long-term ITM call option, which serves as a substitute for owning the stock. This option has intrinsic value and behaves similarly to the stock.
2. Short-term OTM call: The trader sells a shorter-term OTM call option on the same underlying asset. This generates income in the form of premiums.

The combination of these two positions allows the trader to benefit from price movements of the underlying asset while earning premium income.

Before implementing the PMCC strategy, it is essential to understand its components:

• Underlying asset: This can be a stock or index, such as Nifty, that serves as the basis for the options contracts.
• Deep ITM call option: This is the long-term option purchased to replace owning the stock. It should have a high delta (typically above 0.80) to closely mimic the stock’s price movements.
• Short-term OTM call option: This is the option sold to generate income. It is typically chosen with a strike price above the current price of the underlying asset.

Select the underlying stock or index

Choose a stock or index that you believe will remain stable or increase in value over time. For Indian investors, popular choices include Nifty 50 stocks or the Nifty index itself.

Buy a long-term deep ITM call

Purchase a long-dated (6–12 months or more) ITM call option. Ensure that the strike price is significantly below the current market price of the underlying asset. This option acts as a substitute for owning the stock.

Sell a shorter-term OTM call

Sell a short-term OTM call option on the same underlying asset. The strike price should be higher than the current market price. This generates premium income and offsets part of the cost of the long ITM call.

To calculate the breakeven point for a PMCC strategy:

• Add the cost of the long ITM call to the strike price of the short OTM call. Subtract the premium received from selling the OTM call.

For potential returns:

• If the underlying asset’s price remains below the strike price of the short OTM call, the trader keeps the premium as profit.
• If the price rises above the strike price, the profit is limited to the difference between the strike prices of the two options minus the net cost of the setup.

Like any trading strategy, the PMCC requires active management to maximise returns and mitigate risks.

Rolling the short call

If the underlying asset’s price approaches the strike price of the short OTM call, you may roll the option to a higher strike price or a later expiration date to avoid assignment and continue earning premium income.

Adjusting the long call

If the long ITM call loses significant value due to changes in the underlying asset’s price or volatility, you may consider closing the position or replacing it with a new ITM call option.

Like any trading strategy, the PMCC requires active management to maximise returns and mitigate risks.

Rolling the short call

If the underlying asset’s price approaches the strike price of the short OTM call, you may roll the option to a higher strike price or a later expiration date to avoid assignment and continue earning premium income.

Adjusting the long call

If the long ITM call loses significant value due to changes in the underlying asset’s price or volatility, you may consider closing the position or replacing it with a new ITM call option.

Advantages and disadvantages of poor man’s covered call

Advantages

• Lower capital requirement: The PMCC eliminates the need to purchase the underlying stock, making it accessible for investors with limited funds.
• Potential for income generation: Selling OTM calls allows traders to earn premium income.
• Flexibility: The strategy can be adjusted by rolling or replacing options as market conditions change.

Disadvantages

• Risk of assignment: If the underlying asset’s price exceeds the strike price of the short call, the trader may be forced to sell the ITM call at a loss.
• Limited profit potential: The maximum profit is capped by the difference between the strike prices of the two options.
• Complexity: PMCC requires a good understanding of options trading and active management.

Poor man’s covered call vs standard covered call

Example: Using Nifty stock as the underlying asset

Consider a PMCC strategy using Nifty as the underlying asset:

1. Buy a deep ITM call: Purchase a long-term call option with a strike price of Rs. 17,000, expiring in 12 months, for Rs. 2,000 premium.
2. Sell a short-term OTM call: Sell a call option with a strike price of Rs. 18,000, expiring in 1 month, for Rs. 200 premium.

Breakeven calculation:

• Breakeven = Rs. 17,000 (ITM strike price) + Rs. 2,000 (ITM premium) − Rs. 200 (OTM premium) = Rs. 18,800.

Potential return:

• If Nifty remains below Rs. 18,000, you keep the Rs. 200 premium as profit.
• If Nifty rises above Rs. 18,000, your profit is capped at Rs. 1,000 (difference between strike prices minus net cost).

Key takeaways

• PMCC is a cost-effective alternative to the standard covered call strategy.
• It involves buying a long ITM call and selling a short OTM call.
• The strategy is suitable for investors with limited capital but requires active management.
• PMCC has capped profit potential and carries risks like assignment and option value depreciation.
• Practical examples, like using Nifty stocks, can help beginners understand the strategy better.