Poor Man’s Covered Call: What Is It & How To Use It?
What Is a Covered Call?
One of the advantages of options trading is the ability to tailor different strategies to your needs. In this article, you will learn about such a strategy as a poor man’s covered call. Essentially, it is a customized version of a covered call.
In short, a basic covered call includes selling a call on an asset which the investor already owns. By doing so, the investor is essentially setting a ceiling price for the asset, at which they are willing to part with it. They also collect a premium for selling the option, adding to potential profits or offsetting potential losses.
Now, as we explained a covered call, let’s proceed to the poor man’s covered call.
What Is a Poor Man’s Covered Call?
The poor man’s covered call, or PMCC, is a slight modification of the traditional covered call. As its name implies, the strategy is specifically tailored for traders who want to limit their upfront costs. Instead of purchasing the base asset, for example Bitcoin, the trader buys a long-dated, in-the-money (ITM) call on Bitcoin.
Then, they sell a shorter-dated out-of-the-money call against it. The long-dated option acts as a replacement for owning the Bitcoin outright.
Poor Man’s Covered Call vs Covered Call
While both strategies involve the selling of call options, the stark difference lies in the asset ownership aspect.
In a traditional covered call, the investor possesses Bitcoin physically or digitally in a wallet. Conversely, a poor man's covered call strategy substitutes the asset with a deep-in-the-money call option. As the option is much cheaper than the asset, the entry cost is much lower. That is why the PMCC can be an attractive choice for those who want exposure to Bitcoin but may not have the capital to purchase it outright.
Lowering the Cost of a Covered Call
Naturally, the question arises – how does a poor man's covered call lowers the costs associated with a traditional covered call? The answer is fairly simple. Buying Bitcoin outright can be capital intensive, especially given its price volatility.
However, a poor man's covered call strategy bypasses this hurdle. Instead of purchasing Bitcoin, the trader buys a long-term, deep-in-the-money call option, which requires less capital. This not only reduces the cost of entry, but also limits the maximum possible loss to the amount spent on the option.
Poor Man’s Covered Call Risks
The primary risk of the strategy is the possibility of the asset moving in the unfavorable direction. This risk is especially high when it comes to volatile assets, such as Bitcoin. As a result, the trader will incur a loss of the initial premium paid for the long call.
Second, the potential gain is capped. Even if the base asset’s price soars, your profit will be limited to the strike price of the short call, minus the premium received.
Moreover, a poor man's covered call strategy involves potential opportunity cost. Imagine the base asset’s price shoots up beyond the strike price. In this case, the trader would miss out on the gains beyond that point.
How to Set Up a Poor Man's Covered Call
Here's how to set up a poor man’s call:
- Select an option that's deep in-the-money with an expiration that's several months away. This is your long call.
- Next, sell a shorter-dated out-of-the-money call against it.
The end goal is for the shorter-dated call to expire worthless, allowing the trader to keep the premium and repeat the process. If the base asset’s price stays under the strike price of the short call, this goal will be achieved.
Setting Up a PMCC in Bitcoin
Let's walk through a poor man's covered call example with Bitcoin as a base asset.
Suppose Bitcoin is currently trading at $20,000. You decide to buy a deep-in-the-money call option with a strike price of $16,000, expiring in six months. This option costs you $5,000.
Next, you sell a short-dated out-of-the-money call option with a strike price of $22,000, expiring in one month, and receive a premium of $1,000.
Here, the long call gives you the right to buy Bitcoin at $16,000, while the short call obligates you to sell Bitcoin at $22,000 if it goes above that price before the option expires.
Max Profit Potential
The maximum profit scenario for a PMCC arises when the base asset’s price, at the expiration of the short call, is above the strike price of that short call. In this situation, the short call will be assigned and you, as the holder of the PMCC options, are obligated to sell your long call to fulfill your obligation.
Let's continue with the example above to calculate the maximum profit.
If Bitcoin's price rises above $22,000 (the strike price of the short call) at its expiration, your maximum profit is calculated as follows:
Max Profit = (Strike Price of Short Call – Strike Price of Long Call + Net Premium Received) * Bitcoin Contract Size
In our example, it will be:
Max Profit = ($22,000 – $16,000 + ($1,000 – $5,000)) * 1 = $2,000
Max Loss Potential
On the other side, the maximum loss situation in a PMCC occurs when the price of the base asset is below the strike price of the long call at its expiration. Both options will expire worthless in this situation.
Your maximum loss is the initial debit paid to establish the spread. That is, the cost of the long call minus the premium received from the short call.
In the same example above, the maximum loss would be:
Max Loss = Cost of Long Call – Premium Received from Short Call
Max Loss = $5,000 – $1,000 = $4,000
Remember, the maximum loss in a PMCC is limited to the initial debit paid to establish the position, which is usually significantly less than the cost of buying the underlying Bitcoin outright.
IV and Time Decay in the Context of Poor Man’s Covered Calls
Now, let's talk about the role of Implied Volatility (IV) and time decay in poor man's covered calls.
In the PMCC strategy, time decay works in your favor. This is because the time decay of the short call is higher than that of the long call, which can result in a net positive theta.
On the other hand, Implied Volatility (IV) can affect your PMCC position. If IV increases, both options will increase in value, but the short call will increase more due to its shorter expiration, potentially leading to a loss.
Conversely, if IV decreases, both options will decrease in value, but the long call will lose more, leading to a loss. Hence, monitoring IV and adjusting your position accordingly is critical.
How to Choose Strike Prices
As a trader venturing into the realm of PMCC, it's crucial to choose the right strike prices. There are two guidelines that can help you make an informed decision.
Guideline #1: Buying a Deep ITM Call With 90+ DTE
The first step involves buying a deep in-the-money call option with 90+ days till expiration (DTE). This option acts as a replacement for owning the underlying Bitcoin. Buying a deep ITM call ensures that the option has a high delta, which means it will move closely with the price of Bitcoin.
Guideline #2: Short an OTM Call With
Next, you short an out-of-the-money call with a lower DTE. This option is sold to collect the premium and limit the potential risk. It should be noted that the strike price of the short call should be above the current Bitcoin price. This is to increase the likelihood that it will expire worthless.
Be Careful of the Entry Cost
Lastly, while setting up a PMCC, be mindful of the entry cost. Ensure that the cost of the long call is significantly offset by the premium received from the short call. This is crucial in managing potential risks and boosting overall returns.
How to Find the Best Poor Man’s Covered Calls to Enter
Finding the best PMCCs to enter can be a challenging task. One of the ways to identify profitable opportunities is to look for assets with high implied volatility, as they will have expensive option premiums, providing a higher potential profit.
Also, consider your outlook on the asset’s price. For instance, you choose cryptocurrency as a base asset, such as Bitcoin. If you expect the price of Bitcoin to rise moderately over the next few months, a PMCC could be an effective strategy.
How to Manage a Poor Man's Covered Call
Effective management of a poor man's covered call involves regular monitoring and adjustment of your position. If the price of Bitcoin rises above the strike price of the short call, you may choose to roll the option to a higher strike price to avoid assignment.
If the price falls, you can close the position to limit your losses. Always be mindful of the market conditions and adjust your position accordingly.
How to Close a Poor Man's Covered Call
Closing a PMCC position can be done in two ways. You can choose to close both the long and short positions simultaneously, or you can let the short call expire worthless and sell the long call in the market.
Early Assignment Risk When Trading PMCCs
One risk inherent to poor man’s covered call is early assignment. This occurs when the holder of the short call option decides to exercise their right to buy the underlying Bitcoin before the expiration date.
In this scenario, as a PMCC trader, you would need to sell your long call option to buy the underlying Bitcoin and fulfil your obligation. This could potentially result in a loss if the short call is deep in-the-money, and the long call hasn't gained enough value to cover the cost.
Tax Implications When Trading PMCCs
Generally, any gains made from trading PMCCs are considered capital gains and are subject to tax. However, the specific rate and treatment can depend on factors such as the holding period, your income level, and your country of residence. Always consult with a tax professional to ensure you are complying with all relevant tax laws and regulations.
Tips for Trading Poor Man’s Covered Calls
As we covered the main features of PMCCs, here are a few tips to keep in mind:
- Always monitor the market conditions and adjust your position accordingly.
- Ensure the premium received from the short call significantly offsets the cost of the long call.
- Be aware of the early assignment risk, and be prepared to manage it. Consider the tax implications of trading PMCCs, and consult with a tax professional if needed.
Alternative Strategies to Consider
While the poor man's covered call strategy can be an effective tool for Bitcoin trading, it's always wise to consider alternative strategies. Depending on market conditions and your individual risk tolerance, other strategies such as long straddles, strangles, or even the traditional covered call strategy could be more suitable.
Conclusion
In conclusion, the poor man's covered call offers a way to trade with a lower capital requirement. However, as with any trading strategy, it is not without risk. A successful PMCC trader must understand these risks, monitor the market conditions closely, and be prepared to adjust their position as necessary.
FAQ
What Is a “Poor Man’s Covered Call” Strategy, and How Can It Be Used With Bitcoin?
The poor man's covered call, or PMCC, allows the trader to mimic the benefits of a covered call strategy with less capital. If we take Bitcoin, this strategy will involve buying a deep in-the-money call option on Bitcoin and selling a shorter-dated out-of-the-money call against it.
How Can I Limit My Losses When Using the “Poor Man’s Covered Call” Strategy With Bitcoin?
The maximum loss in a PMCC strategy is the initial debit paid to establish the spread, which is the cost of the long call minus the premium received from the short call. To limit losses, traders can close the position if the price of Bitcoin falls below the strike price of the long call.
How Can the “Poor Man’s Covered Call” Strategy With Bitcoin Impact My Tax Situation?
Trading PMCCs can have tax implications. Any gains made from the strategy are generally considered capital gains and are subject to tax. However, the specific tax treatment can depend on various factors, such as the holding period, your income level, and your country of residence. Always consult with a tax professional to understand your obligations.
