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Poor Man’s Covered Call: Selecting the Best LEAPS Strike

The Poor Man’s Covered Call (PMCC) is a covered call writing-like strategy where deep in-the-money LEAPS options are used in lieu of long stock positions. Short-term out-of-the-money call options are sold against the long position. The technical term is a long call diagonal debit spread.  When setting up the initial trade, decisions must be made on the strikes of the 2 legs. This article will focus in on the best strike for the LEAPS position.

 

PMCC: Initial trade structuring

PMCC trades must be constructed such that the difference between the 2 strikes plus the initial short call premium is greater than the cost of the LEAPS option:

[(Short call strike – LEAPS strike) + short call premium] > Cost of LEAPS option

By integrating this formula into the strategy, we are assured that, if we are forced to close the trade when share price appreciates dramatically, we can close at a profit. Short call out-of-the-money premiums are based on our initial time-value return goal range. Amounts will be dwarfed by the cost of the LEAPS position or the difference between the strikes. So, how far deep in-the-money should we go to align with our initial trade structuring formula? We will use a real-life example with SPDR S&P 500 ETF Trust (NYSE: SPY) to shed light on the process.

 

SPY: A LEAPS strike that doesn’t work using the BCI PMCC Calculator

BCI PMCC Calculator: SPY Calculations with $225.00 Strike

 

  • SPY trading at $323.00
  • $225.00 LEAPS cost $108.00
  • $326.00 call generates $0.66
  • Initial trade structuring results in a loss of $6.34
  • [($326.00 – $225.00) + $0.66} < $108.00 (should be > $108.00)

The problem is that the time-value of the $225.00 LEAPS is way too high. The intrinsic-value is ($323.00 – $225.00) = $98.00, leaving a time-value component of $10.00. To mitigate this problem, let’s look for a deeper in-the-money LEAPS strike which has a much lower time-value component.

 

SPY: A LEAPS strike that does work using the BCI PMCC Calculator

 

PMCC CALCULATOR for SPY

  • SPY trading at $323.00
  • $150.00 LEAPS cost $174.09
  • $326.00 call generates $0.66
  • Initial trade structuring results in a gain of $2.57
  • [($326.00 – $150.00) + $0.66} > $174.09 (meets are initial structuring required formula)

 

Discussion

When setting up our PMCC trades, strike selection must allow the trade to align with our initial structuring formula. This includes selecting a LEAPS option with a minimal time-value component. If the time-value is too high, look for deeper in-the-money strikes that have less time-value.

 

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About Alan Ellman

Alan Ellman loves options trading so much he has written four top selling books on the topic of selling covered calls, one about put-selling and a sixth book about long-term investing. Alan is a national speaker for The Money Show, The Stock Traders Expo and the American Association of Individual Investors. He also writes financial columns for both US and International publications along with his own award-winning blog.. He is a retired dentist, a personal fitness trainer, successful real estate investor, but he is known mostly for his practical and successful stock option strategies.

22 Responses to “Poor Man’s Covered Call: Selecting the Best LEAPS Strike”

  1. Michael February 20, 2021 2:12 am #

    Hi Alan,

    Is there an Ask Alan video that addresses the time on expiration Friday that contracts expire or are exercised if ITM?

    On the member page the Ask Alan videos are numbered but not named so there’s no way to even hazard a guess on which might cover this question.

    In my searching online I find conflicting information from the various “experts”.
    My current understanding is that options expire at 4 p.m. on expiration Friday, meaning they no longer trade. But the underlying stock can keep trading after hours so what’s ITM at 4 p.m. may be OTM by 5 p.m., or vice versa.
    I presume that ITM options will automatically exercise based on the 4 p.m. closing price. But is the definition of “ITM” variable?
    Is there a set time when the contract holder must declare that the contract will be exercised?

    Thanks,
    Michael

  2. Barry B February 20, 2021 8:44 pm #

    Premium Members,

    This week’s Weekly Stock Screen And Watch List has been uploaded to The Blue Collar Investor Premium Member site and is available for download in the “Reports” section. Look for the report dated 02/19/21.

    Also, be sure to check out the latest BCI Training Videos and “Ask Alan” segments. You can view them at The Blue Collar YouTube Channel. For your convenience, the link to the BCI YouTube Channel is:

    http://www.youtube.com/user/BlueCollarInvestor

    On the front page of the Weekly Stock Report, we now display the Top 10 ETFs, the Top SPDR Sector Funds, and the 4 single Inverse Index Funds. They are sorted using the 1-month performances from the Wednesday night ETF report and the prices from the weekend close.

    Premium Members…the report for 03/05/21 will be uploaded on Monday, 03/08/21 in the late afternoon.

    Best,

    Barry and The Blue Collar Investor Team

    [email protected]

  3. Barry February 21, 2021 1:53 am #

    Hello again Alan,

    I am becoming increasingly interested in selling calls on high volatility stocks or etfs with in the money strikes. I find I can get sometimes as much as 6-9% or so for relatively deep in the money. A good example now is marijuana etfs like yolo, mj,, msos or potx. Bidu is another example. What do you think?

    Thanks as always,
    Barry

    • Alan Ellman February 21, 2021 7:32 am #

      Barry,

      There is no universal right or wrong to your question. If the initial time-value return goal range aligns with our personal risk-tolerance, it should be considered. My personal sweat spot is 2% – 4% per-month for near-the-money strikes. I’ll go as high as 6% in a strong bull market, never higher. Those are the right numbers for me but not for everyone.

      High implied-volatility means greater risk. Even when we use deep ITM strikes, a 6% – 9% initial time-value return means we are incurring an above-average risk level. The number may appear enticing but we must factor in the possibility of substantial share price decline. That said, those with a higher risk-tolerance, will have opportunities to generate significant short-term profits.

      One way to mitigate, is to use even deeper ITM strikes, with less time-value returns and greater intrinsic-value downside protection.

      One size does not fit all.

      Alan

  4. Donna L February 21, 2021 3:22 am #

    Dear Alan

    Re: XLC March options

    following the BCI rules there does not appear to be any options OTM or Near the Money or ATM that will give a 1-2% premium and have open interest of 100 contracts.

    However some do have a less than .30 bid ask but not 100 options contracts open.

    Do they have to have 100 open contracts and a less than .30 spread or can they have either 100 open contracts or .30 spread?

    I am looking at the 71 strike that has a lot of open interest and using 2.85 as the premium = 1.37 time value= 1.37/72.48 = 1.9% yield. I am confused as to how deep in the money one should go.

    thanks

    Donna

    • Alan Ellman February 21, 2021 7:42 am #

      Donna,

      These are important questions:

      1. I have found that the weekend before a new monthly contract is beginning, the option liquidity will not be as robust as when the market re-opens on Monday. I would re-check after 11 AM ET tomorrow.

      2. One of our main objectives is cash generation (along with capital preservation) determined by our initial-time-value return goal range. For ETFs like the Select Sector SPDRs, 1% – 2% is reasonable. If OTM strikes do not meet our goal range and system requirements (they may tomorrow), then we look to ITM strikes that do.

      Re-check tomorrow.

      Alan

  5. Terry February 21, 2021 8:44 am #

    Alan;

    In your LEAPs example above, you are looking for deeper ITM LEAPs with less time value to satisfy the formula. Of note is that not only did you go deeper ITM but also shorter in duration from Dec 2022 to Jan 2021. The shorter duration impacts time value also.

    Best;
    Terry

    • Alan Ellman February 22, 2021 5:33 am #

      I always say that our BCI community has the most astute investors…

      Alan

  6. Michael February 21, 2021 11:12 am #

    Allen, thanks so much for my first 4 weeks of support.

    I complete my first “refresher” month of paper trading and did quite nicely, utilized most of exit strategies, on $100,000 paper account with margin, I held 25 total positions, 56 contracts, created about $13K in ROO, 21 of 25 were unwound or called out, 4 I will be reviewing to see if they qualify for next month calls, I tried the rollout or roll up, but none made sense.

    In any event, a weird event. on GRBK I sold the 20 call below ITM for $2.00, stock closed Friday at 20.25 but it wasn’t called out, my option expired and left my account on Saturday but my stock was not sold??? Have you ever seen this??? Maybe because it’s just paper??? Just wondering, have a great weekend…

    Michael

  7. BajaPete February 21, 2021 3:58 pm #

    Selecting the Best LEAP Strike. Here is a rule of thumb. Select a strike where the extrinsic value is less than 1% per month of the stock price. This allows price appreciation in the leap at a optimal extrinsic price.

    The AAPL example attached provides an example.

  8. Dimitris February 23, 2021 5:54 pm #

    Hi Alan,
    I sold cover calls of SNAP June 18/21 @ srike 75. The stock is going crazy (today,still in Feb.) and SNAP closed at 71. I want to keep the stock but if I buy the calls back I will be losing
    4.000 dollars. (sold at 5.00 and today
    it trades at 8.90) I want to stop that.
    Any advice?

    Thank you.

    Dimitris

    • Alan Ellman February 24, 2021 6:28 am #

      Dimitris,

      At this point, this is a winning trade. Even if the short call is closed, share appreciation will result in a net credit.

      Now, June 18th is a long way away. There is no way to predict where the price will be at expiration. On top of that, we have the May 6th earnings report which can heavily influence the price in either direction. In our BCI methodology, we avoid earnings reports.

      When we enter a covered call trade, we win if share price moves down slightly, stays the same or moves up. That’s where you are now.

      If you are okay going through an earnings report (I am not) and your bullish assumption on SNAP is in place, no action is required at this time.

      If there is concern regarding the May 6th earnings release, the short call should be closed prior to that date and either sell SNAP or hold it through the report and write a new call after the report passes.

      We also will generate higher annualized returns with shorter-dated options.

      This trade is an excellent learning experience.

      So far, so good.

      Alan

  9. Sunny February 24, 2021 9:22 am #

    Hi Alan,

    Do you think it makes sense to use GTC orders for option selling when applying ‘hit-a-double’ strategy?

    For example 20% rule was executed and the option was bought back for $1.00 and when we place GTC order to re-sell the same option for $2.00.

    Sunny

    • Alan Ellman February 25, 2021 5:39 am #

      Sunny,

      Yes, this is a reasonable approach especially if we have a specific target price in mind. It is also useful if we can’t monitor our trades during the course of a trading day.

      Alan

  10. Alan Ellman February 24, 2021 4:49 pm #

    Premium members:

    This week’s 4-page report of top-performing ETFs and analysis of the top-performing Select Sector SPDRs has been uploaded to your premium site. One and three-month analysis are included in the report. Weekly option and implied volatility stats are also incorporated.

    The mid-week market tone is located on page 1 of the report.

    For your convenience, here is the link to login to the premium site:

    https://www.thebluecollarinvestor.com/member/login.php

    NOT A PREMIUM MEMBER? Check out this link:

    https://www.thebluecollarinvestor.com/membership.shtml

    Alan and the BCI team

  11. Sean February 25, 2021 1:54 am #

    Alan,

    Thanks for the information. I am new and I have a question regarding a covered option I did last week.

    Details:

    I purchased RCL in April for $26/share. I have already re-claimed my investment and still have 200+ shares.

    I sold 2 covered calls both at 80 strike on 2/17/2021.
    I expires on 1/21/2022 and I received 17.35/share. Still have 11 months left

    2nd expires 2/26/2021. I received 1.79/share. Only have 2 days left to expiration.

    The price of the stock shot out the roof and is now $96/share.
    I looked to roll the option, but does not look like a good deal based on the income/negative income it costs.

    Would it be a good idea to buy-to-close @ $16.00/ share and then sell to open at $18.00/share ~50 days out?

    I did tell myself that I would be happy with 80 strike. But wanted your opinion on if there might be a move here to keep the stock because it got so much movement in the past 7 days. $20+/share movement I was not expecting.

    I did read in one of your sheets to not try to catch a falling knife. And the other comment to just take the money on the strike price and move on.

    I won’t take anything you reply to me as advice on what I should do, but only as your opinion of what you might do. I will analyze all information and make my own decision on proceeding with this option.

    Thanks,
    Sean

    • Alan Ellman February 25, 2021 9:02 am #

      Sean,

      You currently have 2 successful trades with RCL.

      With the 2/26 expiration, the shares are worth $80.00 because of the contract obligation. Allowing exercise at $80.00 will result in a nice short-term profit and free up the cash for a new covered call trade with a different security.

      Rolling the option will require a positive response to the question: Would i buy RCL today at the current price?” If yes, roll. If no or not sure. allow assignment.

      The 1/21/22 expiration is too far into the future to make meaningful predictions. There are 3 earnings report to deal with which all present risk. Also, the implied volatility of RCL is 67.80 compared to 16.79 for the S&P 500… we are dealing with a risky security.

      We should also keep in mind that we will generate higher annualized returns with shorter-dated options despite the enticement of the large premiums associated with LEAPS.

      That said, you currently have 2 winning trades which can be managed to successful outcomes.

      Alan

      • Sean February 26, 2021 6:17 am #

        Thanks Alan. You just made me realize that I could be getting too greedy. And with greed comes failure. I was trying to change my plan to get more money.
        I would not buy rcl at this time.
        I was happy with getting 80/sh. That was my first covered call.

        Thanks,
        Sean

  12. Ted February 25, 2021 12:02 pm #

    Hi Alan.

    I was wondering your thoughts on stocks that received a significant downgrade by analysts on which positions were opened a few days ago.

    Your insight would be appreciated as always.

    Be well.

    Ted

    • Alan Ellman February 26, 2021 7:06 am #

      Ted,

      Analyst downgrades alone are not a reason to flee a stock. Median analyst rating (MAR…. in our premium stock reports) is a broader view of analyst consensus and even that alone, if moving down a bit, is not a reason to flee a stock.

      Once we enter a position, we monitor as set forth in the BCI exit strategy and position management rules and guidelines.

      Alan

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