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.
For more information on the PMCC strategy:
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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
Michael,
The “Ask Alan” video titles are listed on the right side of the member page. See the screenshot below.
Also, here is a link to an article I published on this topic:
https://www.thebluecollarinvestor.com/expiration-dates-versus-expiration-times-important-clarifications/
CLICK ON IMAGE TO ENLARGE & USE THE BACK ARROW TO RETURN TO BLOG.
Alan
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]
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
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
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
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
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
I always say that our BCI community has the most astute investors…
Alan
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
Michael,
Congratulations on a great start.
This, most likely, was a result of using a paper-trade platform.
However, there are times when a strike that is ITM at 4 PM ET will not be exercised, rare but possible. Here is a link to an article I published on this topic:
https://www.thebluecollarinvestor.com/expiration-dates-versus-expiration-times-important-clarifications/
Alan
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.
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
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
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
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
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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
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
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
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
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
Hi Alan,
The Blue Collar Investor appears to favor covered call writing vs PMCC. (Read your book on alternatives to Covered Call writing) What are the situations you prefer the PMCC or do you generally allocate a percentage of your portfolio to the strategy. I love using your setup formula for PMCC and alleviates the fear of losing the LEAPS and losing money. It appears to me the % gains are better with the PMCC, I can diversify/allocate funds across more stocks. Lose less hard dollars if the Stock/LEAP go down. Negative is my dollars with a LEAP are probably less than with Stock and I’m losing some value to Theta but that should be minimized with the proper setup. Am I missing something? I’m seeing 12%-18% ROO and 40%-60% total 1 month upside. Other than screwing up my first RKTPMCC trade (which I’ve now rolled to profitability), this has been working well.
Jay,
If we master the 3 required skills and understand the pros & cons of the PMCC strategy (see page 105 of “Covered Call Writing Alternative Strategies”), we can make money.
The main disadvantages that motivate me to favor traditional covered call writing are the long-term commitment to the underlying security and retaining positions through multiple earnings reports. Most importantly, I have had significant and consistent success with traditional covered call writing.
Now, you are 100% correct that the returns will be higher when structuring our trades because the capital investment is lower. You have identified the main benefit of the strategy.
In our book and PMCC Online video course, we stress that the PMCC strategy is much more than “covered call writing but cheaper” It has a lot of moving parts and those aspects must be mastered prior to entering PMCC trades or making it our go-to strategy.
Let me re-state that we can make money with this strategy but serious education and paper-trading must come first.
Alan
Hello Alan
Regarding PMCC
What really) happen if an early assignement of short call occur?
Do you know the zebra strategy to remove any exstrinsic value from LEAPS to obtain a delta of 1 (or -1)?
Do you think could be possible to open and manage a delta neutral position with deep ITM LEAPS?
Leonardo,
Most brokerages will automatically exercise the long LEAPS to provide the shares for the contractual short call obligation. Check with your broker to determine how this is managed in your specific situation.
The ZEBRA (zero extrinsic back ratio) is a stock replacement strategy which has a 50% probability of success. 2 ITM calls are purchased and 1 OTM call is sold. I do not use this strategy although it may be appropriate for others.
For the PMCC strategy, my preference is to purchase a deep ITM LEAPS with Deltas above 75, not necessarily at the 100 Delta required by Zebra. So, 2 legs, not 3.
In addition, because ZEBRA has 3 legs, there is much more management required.
Alan
Alan,
Hi, I love all your content, and even have a couple of your books. I’ve been using ZEBRAs for a couple months now, and a search on those led me here.
I don’t know if you have later content or comments about ZEBRAs, but here you seem to be saying that your long Calls have to be at 100 Delta. They don’t, and that’s the beauty of it: buy 2 Calls at ~75 Delta, sell the ATM Call (ostensibly 50 Delta), and you have a 100 Delta *position*, same as stock.
And as long as they go your way, there’s no management required because there’s *no theta*. Near the end of their life, sell them and re-up into another one if you want.
I think I’m correct about all that, but let me know if I’m missing something.
Thanks,
Mike in Atlanta
Mike,
You are 100% correct that the PMCC can be used with ZEBRAs, in that the ZEBRA acts as a stock surrogate as do deep ITM LEAPs.
In essence they are synthetic stock positions with Deltas near 100.
In the BCI methodology, we use Deltas between 75 and 100 and consider the PMCC a long-term strategy. We recommend rolling our long LEAPS positions about 90-days prior to contract expiration. Cash must be set aside (about $2.00 – $3.00 per-share) when rolling every 1 – 2 years. The short call is the active leg of the trade.
I have never used ZEBRAs with the PMCC strategy but do see pros & cons. Lower cash requirement is an obvious plus. Adding 2 more legs to the trade is a minus for many retail investors. I also question the frequency of the need for management when using shorter-dated options, as is the case for most ZEBRAs.
Bottom line: I see this as a strategy approach that may be appropriate for more sophisticated investors willing to accept additional management responsibilities in exchange for lower cash outlays.
If you have any PMCC/ZEBRA trades you’d like to share with me, I may publish it in one of our weekly blogs.
Alan