One of the most popular Option trading strategies to generate a consistent income is the Covered Call.
However, many people aren’t able to trade the Covered Call because they are limited by their capital.
In order to trade the Covered Call, you’d need at least 100 shares of the stock.
And buying 100 shares of a stock can be very capital-intensive.
The good news is that there’s an alternative.
And that is by using the Poor Man’s Covered Call (PMCC).
This way you can still sell a Covered Call, but use a fraction of the capital with a stock replacement strategy.
So what exactly is the PMCC and how do you trade it?
What Is The Poor Man’s Covered Call?
The PMCC is a bullish Option strategy that consists of two Options:
- Deep-Tn-The-Money (DITM) Long Call
- Out-of-The-Money (OTM) Short Call
The DITM Long Call has a longer duration than the OTM Short Call.
So for example, the DITM Long Call could be 90 DTE (days to expiration) or even longer with LEAPS Options, while the Short Call could be 30 DTE.
This is also what’s considered a Diagonal Spread.
The difference, however, is that the PMCC is generally associated with a DITM Long Call to act as a stock replacement.
A DITM Long Call would have a delta of more than 70.
Whereas for a normal Diagonal Spread, the Long Call could just be slightly In-The-Money (ITM), At-The-Money (ATM), or OTM.
But in essence, they are categorized as Diagonal Spreads because of the different DTE of the Long Call and Short Call.
The PMCC Risk Profile
The image above is of the PMCC’s risk profile (aka the P&L graph).
The PMCC is a bullish strategy so the market has to go up in order for it to be profitable.
However, the PMCC has a peak in its profit.
And that’s because of the Short Call.
The peak of the profit is where the Short Call strike price is.
And as the market rallies above the Short Call strike price, the profit gets lesser.
So in a sense, the Short Call limits the max profit of the strategy.
And this is the same for the Covered Call strategy.
The reason we want this Short Call is to have a mini-hedge if the market tanks, and also as a form of income.
Ideally, we want the Short Call to expire worthless leaving us with the DITM Long Call.
Remember, the DITM Long Call has a longer duration than the Short Call.
So if the Short Call expires worthless, then we can sell another Short Call to generate more income on the trade.
Hence, the popularity of the Covered Call and PMCC strategy.
Now, you might be wondering, is the PMCC strategy better than the Covered Call strategy?
Let’s find out.
PMCC VS. Covered Call
For this, we will use Starbucks (Ticker: SBUX) as an example to compare the Covered Call against the PMCC.
So we will first simulate a Covered Call strategy on SBUX.
In the chart above, we can see that the current price of SBUX is $83.59.
So to initiate a Covered Call strategy, we would need to purchase 100 shares of SBUX at $83.59.
This would result in a capital outlay of $8,359.
And let’s assume we sold the 25 DTE Call Option at the 88 strike price for $1.20.
So that would equal $120 in premium collected for the Covered Call.
Now, just by calculating the annualized return on the Covered Call on the 100 shares we purchase, it would be:
ROI% = ($120 / $8,359) / 25 DTE x 365 days
= 20.96%
Let’s now compare it with the PMCC.
For the PMCC, let’s assume we bought the DITM Long Call with 543 DTE for $39.95.
So the total capital outlay for the DITM Long Call would be $3,995.
As you can see, the capital outlay is significantly lesser than purchasing 100 shares.
And because of this, the return is much higher.
So the annualized return of the PMCC is:
ROI% = ($120 / $3,995) / 25 DTE x 365 days
= 43.85%
This is more than double the return of the Covered Call.
Furthermore, the PMCC has half the risk of the Covered Call.
That’s because if SBUX goes to zero, the PMCC only loses $3,995 – $120 = $3,875.
But for the Covered Call, the loss would be $8,359 – $120 = $8,239.
The loss is more than double the PMCC.
So is the PMCC better than the Covered Call?
For this, we have to examine the pros and cons of both of them.
Pros & Cons of the PMCC and Covered Call
So here are some of the pros of the PMCC and the Covered Call.
PMCC:
- Cheaper than the Covered Call.
- Lesser risk than the Covered Call.
- Greater return than the Covered Call.
Covered Call:
- The absolute dollar profit is higher because with Long stock you have 100 deltas. Whereas for the PMCC, the delta is lesser than that.
- No expiration date with a Long stock position. Can hold on to the stock until it eventually goes up for an overall profit.
Here are the cons of the PMCC and the Covered Call.
PMCC:
- The absolute dollar profit is lower because the delta of the DITM Long Call will never be as high as a Long stock position.
- Has an expiration date so the trade has to work out by then or it will be a loss. And if you roll the DITM Long Call, it will be for a debit, which means you increase your overall risk of the trade.
Covered Call:
- Much more capital-intensive compared to the PMCC.
- A higher capital outlay means the risk is higher.
- The return is lower since the capital outlay is much higher than the PMCC.
Overall, the PMCC has a slight edge over the Covered Call.
However, that does not mean that the Covered Call isn’t a good strategy.
The Covered Call is meant more for a long-term stock portfolio.
So for example, if you invest in stocks and want to hold them for a long time, then selling Covered Calls on them can help you generate income while they appreciate in the long term.
The PMCC is more for short-term trading.
That means you have no desire to hold the position for a long time.
So if you already have some stocks that you’re holding for the long term, you can sell Covered Calls to get some income.
But if you plan to just trade certain stocks for the short-term, then using the PMCC would be better.
At the end of the day, you don’t have to just choose either one.
You can trade them both!
Harold Hennies says
Great content! I started trading the PMCC in 2021 (albeit at lower deltas for the LEAP@~50-60) and find that it is a very flexible, leveraged alternative to owning stocks that tie up much more capital risk than I would like to take. The obvious issue with the PMCC is when the underlying goes in either direction too strongly. Since I treat PMCC’s as a stock replacement alternative I’ve been able to overcome several “losers” by simply rolling strikes both near and LEAP options up or down accordingly for 2+ years! This requires more maintenance time than I would prefer to do! Any suggestions on how to better minimize this from happening yet remain in the trade? I did see your video on doing call ratio spreads as an addition to covered calls that provides more upside in the event price exceeds the short call. I’m assuming I could do the same with the PMCC? Thank you very much for any advice.
Davis says
The PMCC is a very directional trade so if it goes against you then you would certainly take some heat on the position. So instead of rolling it indefinitely, you might consider taking a loss on the trade when it’s time to take a loss. You win some and you lose some. All part and parcel of the trade! Additionally, you can put on trades that can take advantage of any downside move (i.e. Put Ratio Spread, Bear Call Spread, etc.).
Ling says
If the price of the underlying goes below the long strike, the maximum loss is still capped at the cost of purchasing the long call contract, right?