Options Theory: The Poor Man’s Covered Call | Tackle Trading
Covered Calls are a gateway strategy. They stand at the entrance of the options market, beckoning to stock traders of all stripes to come to the land of milk and money.
Those that heed the call find the domain of derivatives to be a place of plenty. Phrases once foreign become commonplace. Pretty soon sweet-sounding terms like cost basis reduction, volatility dampening, and cash flow creation start rolling off their tongues with ease.
And not only do these freshly reformed equity traders sound good, but they also look good! Nothing makes a mentor prouder than a financial make-over, baby.
But what if you’re not swinging a big figure account? What if you shy away from the lofty price tag of buying 100 shares? Are the fruits of the mighty covered call forever outside of your grasp?
No.
You simply need to take the poor man’s route.
As outlined oh-so-craftily in the Tackle 25 video series, the Covered Call consists of buying 100 shares of stock and selling 1 call option. The challenge facing cash strapped traders is finding enough dough to purchase the stock.
Fortunately, there is an alternative asset you can buy that masquerades as a stock. It walks and talks like a stock but possesses something vital to the poor man — a cheap price tag.
The asset of which I speak is a long call option. But not just any old call will do. You have to buy one that’s learned how to behave like equity. It’s an acquired trait that only comes to calls that sit deep in-the-money.
Delta Can Help Ya
Perhaps the easiest way to spot the optimal call strike is to use delta. Remember, 100 shares of stock boast 100 deltas. That means if the stock rises $1, the 100 share position will gain $100. The reverse is also true with a $1 drop creating a $100 loss in the position.
If you want a long call that acts as a perfect proxy for the long stock portion of a covered call, then buy one with a delta close to 100.
Unfortunately, though cheaper than buying 100 shares of stock, a 100 delta call is still unnecessarily expensive. It turns out a long call with a delta of around 80 or higher is sufficient. There is little value in going the extra distance and buying the deepest of deep in-the-money contracts.
Case Study
Suppose you’re eyeing Apple after this week’s tasty reaction to earnings. But darn it if that $166 price tag isn’t too rich for your blood.
Sounds like the perfect situation for a Poor Man’s Covered Call.
Instead of buying 100 shares we’re going to buy a June $145 call for $25. It carries an 80 delta and only costs 15% of you would have paid to buy the stock. We will sell the March 1st weekly option against it which currently has 29 days to expiration. Per the Tackle 25 guidelines, we’ll sell the $170 strike which has a 39 delta.
Perhaps the easiest way to illustrate just how well the poor boy mimics a real covered call is to display the risk graphs.
Here is the long 100 shares and short 1 March 1st $170 Covered Call position:
And here is the long June $145 call and short 1 March 1st $170 Poor Man’s Covered Call position:
If you missed tonight’s (Jan 31st) Cash Flow Club, go watch the recording. We reviewed this strategy in all its glory.
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Originally published at https://tackletrading.com on February 1, 2019.
