Covered call strategy is probably one of the most popular structured derivative strategy in the investment world. It has a simple logic, it is not extremely risky relative to how risky options can be and it gives you the opportunity to be on the other side of the desk, issuing options and collecting premiums. These are some great opportunities for the wise investor. But, if only the entry to this strategy was a little bit simpler and more convenient…
Usually an option covers 100 stocks. So, in order to sell a call option and own the underlying you need a heavy capital requirement to purchase the 100 shares first. This might not be a huge requirement for a wealthy investor but even then, consider Amazon shares. AMZN trades around $2000 in early 2020, multiply that by 100 and you have a capital requirement of $200.000. Also, if you wanted to optimize your portfolio diversification, it would become even more problematic in terms of capital allocation. Although covered call is still very useful to many institutions and wealthy individuals, many people may not have that much capital available to test a new option strategy, especially if they are new to the options world.
PMCC is a great innovation to mimic this powerful strategy with much less capital, hence the name poor man’s covered call.
But how is this strategy made possible? As you already know what a covered call is, how time decay works and details of selling options from the previous posts, it’s not that complicated to explain PMCCs. However, it would be helpful to understand the LEAPS first.
leaps
LEAPS stand for Long Term Equity Anticipation Securities. Usually they are options with remaining expiration date of 9+ months. If you recall the time decay post, an option’s time value depreciates faster during the second half of its life. This time value loss accelerates as the option’s expiry date approaches. So, buying an option with long shelf life enables you to not lose too much value in the beginning of your investment. The time value losses will be very insignificant to the time value losses that would occur in the later stages of the option’s life. This is one of the characteristics of LEAPS that help them anticipate an equity’s characteristics.
Another point that must be made about LEAPS concerns delta. If you recall the post about greeks, delta is the sensitivity to the underlying price changes. LEAPS optimally have high deltas so they can replicate the stock’s behavior. A delta of 1 means, $1 of price change in the underlying will cause a price change of $1 in the option’s price which is perfectly 1:1 ratio. A delta of 1 perfectly simulates the underlying price change in the option price but an option with 0.80+ delta will still qualify to be a LEAPS option as price movements will still be very close. Delta is usually the highest as an option is deep in the money. The deeper the in the moneyness the closer an option’s delta will be to 1.00.
Below are some examples on Amazon (AMZN) stock. In the first row you can observe short term option parameters. Delta of the in the money option is 0.92 while out of the money has a delta of 0.27 only. Theta is the highest here for the at the money option since the time value is maximum when at the money.
Second row is helpful to observe the delta increase thanks to increased time to maturity. Theta are also smaller here. In the money option with longer shelf life has a delta of 1 which is perfectly suitable for LEAPS. Thetas are all smaller as well in this second row since options are far from their expiry dates.
As covered call is an investment strategy rather than a speculation, it will be helpful to simulate the long stock and short call option as closely as possible in our PMCC. Now that we have more idea of what a LEAPS is, we can move on to uncover the idea of replicating covered calls with less capital.
LEAPS will replace the underlying stock component of a covered call. So, it’s important to choose the LEAPS wisely so that stock’s alternative option is able to perform as closely as possible to the underlying stock. High delta (coming from the in the moneyness) and long-term expiry date will be the key characteristics we are looking for in the LEAPS option that will replace the stock.
Options above are different strike prices (In the money, at the money, out of the money respectively) on the same underlying security with time left to maturity of 1 month.
These 6 option examples on the same underlying (AMZN) are great to demonstrate the greek differences in terms of both in the moneyness and time left to maturity)
Qualities regarding LEAPS can be achieved by purchasing long-term and deep in the money options. Here is a nice graph to further demonstrate Delta’s relationship with the intrinsic value.
Poor Man’s Covered Call is a strategy that replicates Covered Call but with much less capital. It is composed of shorting call options with near term expiration on deep in the money call options with long-term expiration instead of stocks.
Table: Covered call vs PMCC
|
Covered Call |
Poor Man’s |
|
= Long stock + Short call option |
= Long LEAP option + Short call option |
ADVANTAGES AND DISADVANTAGES
Table below shows some of the advantages and disadvantages of the poor man’s covered call in comparison with a regular covered call.
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PMCC VS Covered Call |
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Pros |
Cons |
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Less capital is necessary |
Slightly more complicated |
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Less margin is needed |
LEAPS can have wide bid-ask spreads |
|
Less capital is put under risk |
Delta might change after stock moves |
|
Returns are higher in % |
LEAPS can limit the underlying selection |
|
Smaller Time Decay |
LEAPS can be illiquid sometimes |
It’s clear that PMCCs can be very useful to simulate covered call strategies where capital can be a limiting factor voluntarily or involuntarily. There are many other advantages to advancing your strategy from covered call to PMCC such as increased returns in % on the long LEAPS position. (As the option is expected to have a delta close to 1 and nominally react to the underlying price changes similarly, since the option costs much less as a percentage the return is expected to be much higher. This could be considered partly under the freed capital advantage). Another advantage is that it might be entirely impossible for an investor to engage in covered calls due to margin requirements, but since PMCC enables a similar strategy with much less capital it can be possible to structure the same investment strategy with PMCC.
On the other hand, now instead of 1 short option your long position is also composed of an option and this means more parameters to worry about and potentially more complication and mistakes. It is important for an investor to have expertise in options and such structured strategies or to work with a professional individual or institution. Another potential complication in PMCC investments is that if you need to adjust or unwind your portfolio you would probably incur relatively high trading costs since LEAPS usually trade with wider bid and ask spreads. This underlines the importance of precise calculations in the beginning of the strategy so that a portfolio doesn’t have to be changed very often. Also, if the underlying price changes tremendously, this might cause the LEAPS to not respond in the expected manner in other words its greek parameters such as delta and theta would change again requiring the investment manager to interfere with the composition.
Finally, there is still the short call option from which premiums are collected and obligations might arise in the end of its term. So, this leg of the strategy needs to be monitored simultaneously with the long LEAPS.
In a market where, very little volatility is expected, and the investor doesn’t mind holding the underlying security due to potential upside opportunities, PMCC makes lots of sense to sell those call options against your stock-like-LEAPS and collect the premiums along the way. It is also possible for the investor to practically shift the strategy by stopping to sell call options or close them by covering their positions if a more bullish insight is to arrive. This flexibility and opportunistic nature in covered calls as well as PMCCs are the main attractions making the strategy one of the most popular and utilized structured derivative products.
PMCC Formula
It’s important to follow the following PMCC Formula when initializing the PMCC trade.
Example 1:
Apple (AAPL) is trading at $152.
|
PMCC Strategy (@APPL) |
|
|
Short call |
Long call (LEAPS) |
|
Strike $167.5, term: 1 month |
Strike $140, term: 1 week |
|
Price: $0.85 |
Price: $24.50 |
Short call; Strike: $167.5, maturity: 1 month (option trading at $0.85)
Long call; Strike: $140, maturity: 1 week (option trading at $24.50)
LEAPS Price: $24.50
Premium from Short call sale: $0.85
Short call strike – long call strike = 160 – 140 = $27.5
24.50 < 0.85 + (167.5 – 140)
24.50 < 28.35
Here the formula checks so the strategy could be initiated with these options.
Example 2:
Apple (AAPL) is trading at $152.
|
PMCC Strategy (@APPL) |
|
|
Short call |
Long call (LEAPS) |
|
Strike $160, term: 1 month |
Strike $155, term: 1 week |
|
Price: $2.35 |
Price: $16.13 |
Short call; Strike; $167.5, maturity: 1 month ahead (option trading at $0.85)
Long call; Strike: $140, maturity: 1 week ahead (option trading at $24.50)
LEAPS Price: $24.50
Premium from Short call sale: $0.85
Short call strike – long call strike = 167.5 – 140 = $27.5
16.13 <? 2.35 + (155 – 160)
16.13 <? 7.35
Here the formula fails to check so the strategy shouldn’t be initiated with these options.
