Poor Man’s Covered Call: The Ultimate Guide to This Cost-Effective Options Strategy

What is a Poor Man’s Covered Call: Overview

The poor man’s covered call, also known as a diagonal debit spread, offers investors a capital-efficient alternative to the traditional covered call strategy. 

Instead of purchasing 100 shares of the underlying stock, this approach involves buying a deep in-the-money (ITM) long-term call option while simultaneously selling shorter-term out-of-the-money (OTM) call options against it.

The core components of this strategy include:

• A long-term, deep ITM call option (typically 6+ months to expiration)
• Short-term OTM call options sold periodically against the long call

The primary purpose of the poor man’s covered call is income generation while reducing the capital requirement compared to traditional covered calls. It allows traders to participate in a covered call-like strategy at a fraction of the cost, hence the name “poor man’s covered call.”

Market Outlook & When To Use Poor Man’s Covered Call Strategy

The poor man’s covered call works best in neutral to moderately bullish market conditions. When you implement this strategy, you’re essentially expressing a view that:

• The underlying asset will remain stable or increase slightly in price
• The price won’t rise dramatically above your short call strike
• Implied volatility is relatively high (beneficial when selling the short calls)

This strategy is typically employed when an investor wants exposure to a higher-priced stock but lacks sufficient capital for 100 shares.

The holding period varies—the long call may be held for several months to over a year, while the short calls are typically managed on a weekly or monthly basis.

Regarding volatility considerations, the poor man’s covered call can be beneficial during periods of elevated implied volatility, as this increases the premium received from selling the short-term calls.

Strategy Structure & Mechanics

Setting Up the Poor Man’s Covered Call

1. Purchase a deep ITM call option with at least 6-12 months until expiration (often referred to as a LEAP – Long-term Equity Anticipation Security)
2. Sell an OTM call option with a shorter expiration period against your long call

When selecting strikes for your poor man’s covered call:

• Long call: Choose a delta of approximately 0.70-0.80 (typically 10-20% ITM)
• Short call: Select a strike above the current stock price (typically with a delta of 0.30 or less)

For expiration considerations:

• Long call: Typically 6-12+ months out
• Short call: Usually 30-45 days out, though some traders use weekly options

Example Setup

Let’s say you’re interested in a stock trading at $100 per share. Instead of purchasing 100 shares for $10,000, you could:

1. Buy a 9-month $80 call option (deep ITM) for approximately $2,500
2. Sell a 1-month $105 call option for $200

Your initial investment would be $2,300 ($2,500 – $200), representing a 77% reduction in capital compared to buying the shares outright.

Risk/Reward Profile of Poor Man’s Covered Call

Maximum Profit Potential

The maximum profit for a poor man’s covered call occurs when the stock price is exactly at the short call strike price at expiration. It can be calculated as:

Max Profit = Short Call Premium + (Short Call Strike – Long Call Strike) – Net Debit Paid

Maximum Loss Potential

The maximum loss is typically limited to the net debit paid for the position (cost of long call minus premium received for short call). This occurs if the underlying stock price falls significantly and both options expire worthless.

Break-Even Point

The break-even point at expiration of the long option can be calculated as:

Break-even = Long Call Strike + Net Debit Paid

Payoff Diagram

This visual representation helps you understand the risk/reward tradeoff and see why the poor man’s covered call is considered a capital-efficient alternative to the traditional covered call strategy.

Understanding the Poor Man’s Covered Call Payoff Diagram

The payoff diagram illustrates how a poor man’s covered call strategy performs across different stock prices at expiration. Here’s how to interpret it:

Key Elements of the Diagram:

1. Blue Solid Line: This represents the poor man’s covered call strategy profit/loss profile.
2. Blue Dotted Line: This shows the traditional covered call strategy for comparison.
3. Horizontal Axis: Represents the stock price at expiration.
4. Vertical Axis: Shows the profit or loss amount in dollars.

Important Price Points:

• Break-even Point ($103): The stock price where the strategy neither makes nor loses money.
• Short Call Strike ($120): The strike price of the short call option.
• Maximum Loss Point: Shows that losses are limited to the net debit paid ($23).
• Maximum Profit: Achieved when the stock price is at or above the short call strike at expiration.

Key Takeaways: What This Diagram Tells You?

1. Limited Downside: Unlike owning the stock outright, your maximum loss is capped at the net debit paid ($23 in this example), even if the stock price falls dramatically.
2. Profit Ceiling: Your profit potential plateaus once the stock price exceeds the short call strike price ($120). This differs from simply owning the stock, where profits would continue rising with the stock price.
3. Capital Efficiency: The poor man’s covered call (solid blue line) requires less capital than a traditional covered call (dotted blue line), but both strategies have similar profit potential.
4. Risk Comparison: The traditional covered call has potentially greater losses (shown by the dotted line extending lower) because it requires owning the actual stock.

This profit/loss diagram for a poor man’s covered call resembles a traditional covered call but with a lower maximum loss. It shows profit plateauing at the short strike price and losses limited to the net debit paid.

Poor Man’s Covered Call: Mathematical Examples

Imagine a scenario with a stock trading at $100:

• Buy a 9-month $80 call for $25 ($2,500)
• Sell a 1-month $105 call for $2 ($200)
• Net debit: $23 ($2,300)

Let’s examine various price scenarios at the expiration of the short call:

Scenario 1: Stock at $95

• Short $105 call expires worthless (keep $200 premium)
• Long $80 call is worth approximately $15 ($1,500)
• Position value: $1,700
• Unrealized P/L: -$600 ($1,700 – $2,300)
• You can sell another call for the next month

Scenario 2: Stock at $105

• Short $105 call expires at breakeven (keep $200 premium)
• Long $80 call is worth $25 ($2,500)
• Position value: $2,700
• Unrealized P/L: +$400 ($2,700 – $2,300)

Scenario 3: Stock at $120

• Short $105 call is $15 in-the-money (-$1,500)
• Long $80 call is worth $40 ($4,000)
• Position value: $2,500 ($4,000 – $1,500)
• Unrealized P/L: +$200 ($2,500 – $2,300)

The break-even point at the final expiration of all options would be $103 (Long call strike $80 + net debit $23).

Greeks Impact Analysis

Delta

The poor man’s covered call typically begins with a positive delta (around 0.50-0.60), meaning it benefits from increases in the underlying price—up to a point. As the stock approaches and exceeds the short strike, the position’s delta approaches zero due to the offsetting deltas of the long and short calls.

Theta (Time Decay)

This strategy benefits from time decay in the short call position while simultaneously being hurt by time decay in the long call. However, the rate of decay is greater in the short-term short call, creating a net positive theta effect when managed properly. The theta benefit increases as the short call approaches expiration.

Vega (Implied Volatility)

The poor man’s covered call has negative vega exposure, meaning it generally benefits from decreasing implied volatility. This occurs because the long-term option typically has higher vega than the short-term option. Therefore, a decrease in implied volatility will hurt the long call more than it helps the short call.

For volatility skew, if the implied volatility of the short-term options is higher than that of longer-term options, this can be advantageous when initiating the position.

Gamma

Gamma risk is most pronounced when the stock price approaches the short call strike near expiration. At this point, the position can experience rapid changes in delta, potentially leading to larger-than-expected gains or losses with small movements in the underlying price.

Strategy Adjustments

When the Stock Price Rises Significantly

If the underlying approaches or exceeds your short strike:

1. Roll up and out: Buy back the short call and sell another at a higher strike and/or later expiration
2. Convert to a call debit spread: Consider closing the position or adjusting to capture some profit

When the Stock Price Falls

If the underlying declines:

1. Roll down: Buy back the short call (now cheaper) and sell another at a lower strike to collect additional premium
2. Evaluate the long call: Determine if it’s worth maintaining the position or if closing it entirely makes more sense

Volatility Changes

• Increasing volatility: Consider selling calls with shorter duration to capitalize on higher premium
• Decreasing volatility: Consider selling calls further out in time to collect more premium

Rolling Techniques

Rolling involves closing the current short option and opening a new one. Common rolling approaches include:

• Roll out: Same strike, later expiration
• Roll up: Higher strike, same expiration
• Roll up and out: Higher strike, later expiration
• Roll down: Lower strike, same expiration

Exit Strategies

Optimal Exit Scenarios

Consider exiting the entire position when:

• You’ve collected 50-75% of the maximum potential profit
• The underlying has reached your price target
• Your market outlook has changed

Risk Management

Establish exit points based on:

• Maximum acceptable loss (often 50-100% of the initial credit received)
• Technical support/resistance levels
• Changes in the underlying’s fundamentals

Early Exit vs. Holding to Expiration

Many traders close the short call when they’ve captured 50-80% of the maximum premium rather than holding until expiration. This reduces risk and allows capital to be redeployed.

For the long call leg, consider holding as long as your bullish thesis remains intact or rolling it forward as expiration approaches.

Assignment Considerations

If the stock price exceeds your short call strike near expiration, be prepared for potential assignment. In this case, you would need to either:

1. Exercise your long call to provide the shares (if assigned)
2. Buy back the short call before expiration to avoid assignment
3. Allow assignment and then purchase shares in the market to satisfy the obligation

Advantages of Poor Man’s Covered Call

The poor man’s covered call offers several compelling benefits:

• Significantly reduced capital requirement compared to traditional covered calls
• Lower maximum loss than owning the stock outright
• Ability to generate recurring income through multiple short call sales
• Potential for higher percentage returns on capital
• Defined risk limited to the net debit paid
• Flexibility to adjust as market conditions change

Disadvantages & Risks of Poor Man’s Covered Call

Despite its advantages, this strategy has important drawbacks:

• Limited profit potential compared to simply owning the stock
• Higher complexity requiring more active management
• Exposure to volatility risk (particularly vega risk)
• Potential early assignment risk on the short call
• Time decay working against the long call position
• Risk of the underlying stock falling sharply
• Additional transaction costs from multiple option trades

Tax Considerations

The poor man’s covered call can have complex tax implications:

• Options held for less than a year are typically taxed as short-term capital gains
• The strategy may involve both short and long-term gains
• Assignment of options can create taxable events
• Wash sale rules may apply when rolling positions

Note that individual tax situations vary, and it’s advisable to consult with a tax professional for guidance specific to your circumstances.

Who Should Consider Poor Man’s Covered Call Strategy

The poor man’s covered call is best suited for:

• Intermediate to advanced options traders
• Investors with moderate risk tolerance
• Traders with sufficient knowledge of options mechanics and Greeks
• Investors looking to reduce capital requirements while generating income
• Those willing to actively manage positions (this is not a “set and forget” strategy)

Most brokerages require at least Level 3 options approval to implement this strategy.

Related Strategies

Similar Strategies

• Traditional Covered Call: Higher capital requirement but simpler to manage
• Call Credit Spread: Lower capital requirement but less income potential
• Calendar Spread: Similar structure but different market outlook
• PMCP (Poor Man’s Cash-Secured Put): A capital-efficient alternative to selling cash-secured puts

Comparison with Traditional Covered Call

Common Mistakes to Avoid

1. Using too little time on the long call: Ensure your long call has at least 6+ months until expiration to minimize theta decay
2. Improper strike selection: Choosing a long call without enough delta or a short call with too much delta
3. Ignoring volatility conditions: Failing to consider implied volatility when entering positions
4. Over-allocation: Risking too much capital on a single position
5. Poor management of winners/losers: Not taking profits or cutting losses at appropriate times
6. Neglecting assignment risk: Failing to monitor positions as expiration approaches

Frequently Asked Questions

Q: Why is it called a “poor man’s covered call”?

A: The name comes from its significantly lower capital requirement compared to a traditional covered call, making it accessible to traders with smaller accounts.

Q: How often should I roll the short call?

A: Typically, traders roll when they’ve captured 50-80% of the maximum premium or when the short call approaches expiration.

Q: What happens if I’m assigned on my short call?

A: If assigned, you can exercise your long call to fulfill the obligation, though this will close your entire position. Alternatively, you can buy back the short call before expiration to avoid assignment.

Q: How do I adjust if the stock price falls significantly?

A: You can roll your short call down to a lower strike to collect more premium, though this reduces your protection. In severe cases, you might consider closing the position to prevent further losses.

Glossary of Terms

• LEAP (Long-term Equity Anticipation Security): Options with expiration dates further than 9 months in the future
• Diagonal Spread: An options spread with different strike prices and different expiration dates
• Rolling: Closing an existing option position and simultaneously opening a new one with different terms
• Assignment: When the holder of a short option position is obligated to fulfill the terms of the option contract

Additional Resources

To deepen your understanding of the poor man’s covered call strategy, consider exploring educational materials on:

• Options pricing models
• Advanced Greeks analysis
• Tax treatment of options strategies
• Portfolio allocation and position sizing
• Introductory free course on option investing
• Expert-led courses to master option investment/trading 

Remember that the successful implementation of this strategy requires ongoing option education, practice, and disciplined risk management.

Disclaimer: This content is provided for educational purposes only and is not investment advice. Options trading involves risk and may not be suitable for all investors. Consult with a qualified financial advisor before making investment decisions.