Poor Man’s Covered Call vs. Covered Call: Which Strategy Is Better?

A Smarter Way to Trade: Poor Man’s Covered Call vs. Covered Call

When it comes to options trading, few strategies are as popular and widely discussed as the covered call. This method, alongside its lesser-known cousin, the poor man’s covered call, can be powerful tools for generating income and managing risk. The key difference? One demands a substantial capital commitment, while the other offers a capital-efficient alternative with similar potential. If you’re looking to optimize your portfolio, the poor man’s covered call might be just what you need. Here’s a comparison of both strategies to help you decide which one suits your goals, resources, and risk tolerance.

The Basics of Covered Calls and Poor Man’s Covered Calls

Both strategies share a common goal: generating income through options premiums while managing risk. However, the methods differ in terms of capital requirements, flexibility, and overall approach.

Covered Call

A covered call is a straightforward strategy that involves owning 100 shares of a stock and selling call options against those shares. By doing this, you collect premiums from selling the options, effectively reducing the cost basis of the stock while still holding the potential for capital appreciation (up to the strike price of the call). This strategy is simple to execute, easy to manage, and often seen as a conservative way to generate extra income from stocks you already own.

Poor Man’s Covered Call

The poor man’s covered call, while similar in structure, eliminates the need to own 100 shares of the underlying stock. Instead, it substitutes the stock with a LEAPS (Long-Term Equity Anticipation Security) call option. These long-term options allow you to control a large amount of stock for a fraction of the cost, often reducing your capital requirements by 65% to 85%. This makes the strategy far more capital-efficient, offering traders the same income potential as the traditional covered call but with significantly lower upfront costs.

Poor Man’s Covered Call vs. Covered Call: Which Strategy Is Better?

Let’s break down how the two strategies compare in five key areas: capital requirements, income potential, flexibility, risk, and tax implications.

1. Capital Requirements

• Covered Call: To implement a covered call, you need to own 100 shares of the stock. This can be expensive, especially with high-priced stocks like Microsoft (MSFT) or popular ETFs like SPY. For instance, buying 100 shares of MSFT at $412 would cost $41,200. Such a high capital requirement can limit your ability to diversify or make other trades.

• Poor Man’s Covered Call: The poor man’s covered call uses LEAPS instead of 100 shares, significantly reducing the initial capital outlay. For example, a LEAPS call option can be purchased for a fraction of the cost of buying 100 shares of the stock (roughly $12,500), freeing up capital for diversification or additional trades.

Winner: Poor Man’s Covered Call (for capital efficiency).

2. Income Potential

• Covered Call: By selling a call option against 100 shares, the income is tied to the stock’s price and the strike price of the call. While this strategy provides consistent premium income, the return is somewhat limited, especially if the stock is flat or slightly moves in your favor.

• Poor Man’s Covered Call: The income potential of the poor man’s covered call is similar in that you’re still selling call options. However, because you’ve invested much less capital (thanks to the LEAPS), your return on capital can be significantly higher. This translates into a potentially better return for each dollar invested.

Winner: Poor Man’s Covered Call (for higher return on invested capital).

3. Flexibility

• Covered Call: Owning 100 shares ties up capital, making it harder to adjust positions quickly or diversify into other opportunities. If the trade doesn't go as planned, your flexibility is limited.

• Poor Man’s Covered Call: With LEAPS, you have more flexibility. You can choose the strike price and expiration date of the LEAPS to match your outlook, and you can roll your position more easily when necessary. LEAPS are typically long-term options, allowing you to avoid the rapid time decay seen with shorter-term options.

Winner: Poor Man’s Covered Call (for adaptability).

4. Risk and Ownership

• Covered Call: The covered call strategy offers full exposure to the stock's risks and rewards. This includes capital appreciation and dividends, but also the risk of large losses if the stock declines significantly. However, you are not fully exposed to downside risk since the premium you collect from selling the call provides some cushion.

• Poor Man’s Covered Call: The downside risk is limited to the cost of the LEAPS contract. However, you miss out on dividends, and if the stock doesn't perform well, the LEAPS option could lose value. Additionally, time decay may become a factor, especially if the stock remains flat or doesn’t move much in your favor.

Winner: Depends on your priorities. If you want full exposure to stock appreciation and dividends, the covered call is better. If you’re focused on limiting risk with less capital at stake, the poor man’s covered call is a more suitable choice.

5. Tax Implications

• Covered Call: Gains on stocks held long-term may qualify for favorable long-term capital gains tax treatment. The income generated from the call option is taxed as short-term capital gains, but it’s still more tax-efficient than other strategies that involve frequent trading.

• Poor Man’s Covered Call: The gains from LEAPS and the short-term calls are typically taxed as regular short-term options gains. This means that, unlike long-term stock holdings, the tax rate can be higher for the poor man’s covered call, as it doesn’t benefit from long-term capital gains treatment.

Winner: Covered Call (for tax efficiency).

Why Consider a Poor Man’s Covered Call?

The poor man’s covered call is an attractive strategy for traders looking to maximize capital efficiency, flexibility, and income potential. Here's how it works:

1. Replace Stock with LEAPS: Buy a LEAPS call option that expires in one to two years. LEAPS options tend to have less time decay compared to shorter-term options, making them ideal for a long-term strategy.

2. Sell Short-Term Calls Against the LEAPS: Once you hold the LEAPS, sell short-term call options with strike prices above the current stock price. These options typically have expiration dates 30 to 60 days away, and you can collect premiums, just like in a traditional covered call.

Example: Trading Microsoft (MSFT)

Let’s say MSFT is trading at $412. Buying 100 shares of MSFT for a traditional covered call would cost $41,200. In comparison, you could purchase a LEAPS call option with a $330 strike price for $12,500. That’s a savings of nearly 69.7%. You then sell a 30-day call with a $430 strike price for $350, reducing your net cost to $12,150

In this example, the return on invested capital for the poor man’s covered call is 2.8% over 30 days, while the return for the traditional covered call is only 0.8%. The difference is striking: you’re generating a 2% higher return with much less capital at risk. That’s a potential difference of 24% over the course of one yar.

Statistical Comparison: Covered Call vs. Poor Man's Covered Call

Again, Microsoft (MSFT) is trading at $412 and we're using a 30-day call option with the following conditions:

1. Covered Call

   • Shares Owned: 100 shares

   • Stock Price (AAPL): $412

   • Call Option Sold: $430 strike price, premium of $350

   • Total Cost to Enter: $412 * 100 = $41,200

   • Income from Sold Calls: $3.50 * 100 = $350

   • Potential Profit if Stock Hits Strike Price ($430): $43,000 - $41,200 = $18 per share or $1800

   • Total Potential Return (Income + Capital Appreciation):

     • Income: $350 (from selling calls)

     • Capital Appreciation: $1800

     • Total: $350 + $1800 = $2,150

   • Return on Investment (ROI): 5.2%

2. Poor Man's Covered Call

   • LEAPS Call Purchased: $412 strike price, cost of $12,500

   • Call Option Sold: $430 strike price, premium of $3.50

   • Total Cost to Enter: $12,150

   • Income from Sold Calls: $3.50 * 100 = $350

   • Potential Profit if Stock Hits Strike Price ($430): $3.50 + $15.00 = $18.00 or $1,850

   • Total Potential Return (Income + Capital Appreciation):

     • Income: $350 (from selling calls)

     • Capital Appreciation: $1,500 (430 LEAPS with 0.80 delta)

     • Total: $350 + $1,500 = $1,850

   • Return on Investment (ROI): 14.8%

Summary of Key Metrics:

Conclusion:

As shown in the comparison, the Poor Man’s Covered Call provides significantly higher potential returns on investment due to the reduced capital outlay. Although both strategies generate income from selling call options, the poor man’s covered call allows you to achieve a much higher ROI by controlling the same amount of stock for a fraction of the cost.

This comparison illustrates how, by using LEAPS in place of owning the stock, you can leverage capital more efficiently while still generating comparable (or even better) income potential from the sale of call options. For traders with limited capital, the poor man’s covered call is a far more efficient way to generate significant returns, whereas the traditional covered call might be better suited for those seeking stock ownership benefits and higher tax efficiency.

Whether you choose the traditional covered call or the more capital-efficient poor man’s covered call, understanding each strategy's mechanics and potential is key to optimizing your trading approach.

Trade wisely, manage risk, and keep refining your strategy to meet your goals,

Andy

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