How to Trade a Poor Man's Covered Call

[Music] hey everyone welcome back to the show thanks for tuning in my name is mike this is my whiteboard and today we're going to be talking about some adjustment strategies for a poor man's covered call now if you missed any of the segments this morning there were actually a few of the morning segments on the diagonal spread i think they talked about the poor man's covered call as well as poor man's covered put and some best practices around that so check those out if you missed them but today we're going to just be talking about

some adjustments with poor man's covered calls and what we might consider doing with certain market conditions or changes in the market or the underlying price as we put the trade on so first we need to talk about the poor man's covered call we're going to break down this strategy we're going to highlight a few of the important things to consider when we're putting on this trade on this first slide here so let's get right into that and we'll talk about what the opening trade is and how we can set it up so the opening trade

and really a poor man's covered call is just another way to get into that covered call situation or basically we're replicating that 100 shares of stock with the purchase of a long call that's in the money and it's pretty far out in duration and we're selling a call against that trade so basically we're looking to reduce our cost basis on this long option here as opposed to a traditional covered call which would involve buying 100 shares of stock and then selling that call against it so a setup you might see and a lot of setups

will look this way where we'll basically be straddling the stock price here so let's say the stock price is right at 75 we'll be looking to purchase an in the money call in a far out expiration which we'll be paying quite a bit for but we're going to be reducing that cost basis by selling a out of the money call in a more near-term expiration so as you can see i'm looking to purchase a 70 call that's in the money in may and i'm looking to sell a call against that to reduce my cost basis

on that long call by two dollars by selling a call in april that's out of the money so the combination of these two options creates a diagonal spread we have a similar setup to a vertical spread here where we're straddling the stock price but since we're changing the expiration we're creating that diagonal spread we're not dealing with the same expiration just yet but we are creating a diagonal spread and there's a few things to be cognizant of when we're creating this strategy so let's say that we are able to purchase this for a five dollar

debit now this morning they brought up a great point in the sense that we need to be very aware of the width of our strikes and we need to make sure that we're not paying more than the width of our strikes because if that's the case so in this case my width would be 10 points wide if for some reason i was paying a ton of money on this in the money call and i wasn't able to reduce my cost basis to less than the width of the strikes here then i would put myself in

a peculiar position where i could actually lose money if the stock ended up shooting up through my strikes so for an example if i'm paying ten dollars and two cents for this trade and at as we go along the stock price shoots up and both of these options become very very deep in the money if i paid ten dollars and two cents and i know that at expiration of this short call here this spread will be trading for right around the intrinsic value then i'm going to have to sell out of that trade for right

around ten dollars and if i paid 1002 then i would see myself realizing sort of a net loss on that trade now of course we would have the ability to have implied volatility play a positive role in that scenario where if implied volatility was increasing and my short option here was expiring but i still had that extrinsic value in the may option which would help boost that price up then maybe i wouldn't be in this scenario but it's always good to have a great setup going into the trade and really what we're looking to do

is just pay less than the width of our two strikes here so in this case we've got a perfect setup our break even is right at the price that the stock is trading right now and i'm paying about 50 percent of the width of the strike so this is what a perfect setup would look like now when we consider max profit and the break even here i've got question marks and we're not going to even talk about that in the next few slides but the reasoning for that is because of that implied volatility factor since

i'm dealing with two different expirations i'm going to have the inability to really estimate what the option will be this long call will be worth when this april option expires now the april option if there's a couple hours left before expiration there's not going to be a lot of extrinsic value there even if implied volatility has exploded there's not enough time value to place extra value on that short call so it might be worth 20 or 30 cents even if it's still out of the money but at expiration of the april expiration it's going to

disappear from the account if it's out of the money and that's going to leave me with this long may call and since we never know where implied volatility is going to be which is really a reflection of the options price and the implied movement of that stock we're not really going to be able to calculate the max profit or the break even because of that reason but we do know that our max loss is simply the debit paid for it because we can't lose more than that so even if the stock price drops to 50

both of these options would expire out of the money which would leave us with our max loss of the amount we paid for it which is five dollars of debit or 500 so let's go into the next slide here and we'll talk about what might happen or what we can consider when the stock price starts to move so the very first thing we're going to to talk about is probably the easiest one and that's if the stock price moves up so there is a misconception when we're dealing with any sort of covered call whether it's

a standard covered call or a poor man's covered call and we get a lot of questions on what we can do if the stock price goes up well we are going to see losses on this short call because of the fact that if we originally sold it out of the money and now it's moving in the money which would increase its value and we sold it here now the value is increasing which is going to show us a loss we're probably going to be wondering what can we possibly do or what would we do in

this situation where the stock is going up well for us chances are there's not going to be an adjustment to be made because sure we're going to see losses on this short call in april but we're going to see equal intrinsic value gains on that may long call because we know at the end of the day a long call is going to convert into positive 100 shares or us being long 100 shares if it expires in the money and inversely a short call is going to be converted into negative 100 shares or short 100 shares

at expiration wherever the stock price goes above here if i see losses on the short call it's going to be equally offset by my long call so i should be seeing a profit on this scenario when the stock price goes up so for that reason there's not going to be an adjustment to be made i'm not going to adjust anything because of the fact that this is exactly what i want to happen but there is an adjustment that we might consider when the stock price moves down so let's go into the next slide and we'll

talk about that a little bit so let's say the stock moves down to 68 well of course one thing that we can do is adjust our short option that's going to be the theme when we're moving these sorts of strategies and adjusting these sorts of strategies and the theme is that we can move that short option around the short option is going to be the mobile option so let's take a look at a few things here so if the stock price is down to 68 the first thing i want to consider is the implied volatility

factor if we know that there tends to be a relationship there's not always a relationship with a stock moving down an implied volatility going up but generally that relationship will hold true so if i see the stock price moving down i should see implied volatility moving up so what does that mean from a rolling standpoint well number one that means i should be able to move this call less than i would have to in a situation where implied volatility didn't move and i should be able to still collect a fair amount so what does this

do for me well if i can move my strike down to let's say 76 as opposed to something like 74 and i can collect that same value because implied volatility is increased that's going to be good for me because then if the stock price comes all the way back up my short strike won't kick in until the 76 strike as opposed to the 74. so the further away we can keep this short option the better position we're going to be in in terms of upside profitability potential so one thing we can do is roll the

call down and really all we're doing in in doing that is collecting more premium which lowers our max loss so anytime the stock price moves away from this short call we should see the short call losing value which allows us to move that short call down now in most situations it's going to hopefully we can have it occur in that same cycle so if i can move this call down and collect a credit and still be in the april cycle that's going to be good for me in terms of reducing my max loss and reducing

my overall break even at that expiration of this short call but really one thing we need to consider is what is our assumption now if we had a bullish assumption when the stock price was at 75 but we saw it drop all the way down to 68 i'm probably going to be seeing a pretty sizable loss on this trade so i need to ask myself is my assumption the same do i still believe that by may this stock price can go all the way back up to at least put me at a break even on

this trade or am i comfortable with closing the position out it's something that we're going to have to reassess especially when the stock price has a pretty drastic move downward now one benefit of this poor man's covered call is that if implied volatility does increase that increase in implied volatility will help offset the losses we see on that long call yes we're going to be losing all of that intrinsic value that we saw and as this option is now out of the money but because we would normally see an implied volatility increase we should see

a higher value in that extrinsic value that we'll see in this 70 call now as opposed to if implied volatility didn't change at all so when we're looking at losses from a poor man's covered call standpoint if the stock price does move down the implied volatility increase that usually occurs should help us offset some of those losses but what happens when the stock price stays within the range of our strikes and that's going to be the last slide we talked about today and some of the adjustments that we make and can make at the end

of the day when we have this sort of situation so when we're looking at a stock staying within the range so in this example we had the stock price at 75. now let's say it moved around here and it ended up at 76 at the april expiration well another thing to look at is where is the implied volatility so we can assess where the implied volatility is and at this point if i'm able to either close out my april option that i was short for a couple pennies and move it out into may and create

that strict vertical spread now and i'm able to do that for a nice credit and increase my profit potential to the upside then that's going to be something that i'm interested in so if there's an iv change i might be able to move this short strike up and out which you see here as one of our options so as you can see i'm moving this to may because i'm moving just to the next expiration cycle usually the monthly expiration cycles have the most liquidity so in that scenario i'm going to just be moving it from

april to may and if i'm able to move my strike up a little bit further and collect a fair credit i'm definitely going to do that because if the stock price goes all the way up to 82 now and this spread expires fully in the money i'll be able to close out of this spread for twelve hundred dollars it's just the difference between my long may call and my short may call here which is twelve points so i would have effectively added another two hundred dollars of potential bonus profit from making that roll and if

i'm able to collect even more from this short call i can add that to my profit potential or my max or reduce my max loss in that sense as well so that is one thing that we can do if the stock stays within our range and we're able to move that short call but again when we're collecting more premium all we're really concerned about is lowering our max loss or lowering our cost basis as you hear all the time so let's wrap this up with some takeaways for you the very first takeaway is that a

diagonal spread has some key concepts number one we're going to be looking for deploying this in a low implied volatility environment and that's because we want to see implied volatility increase when we're long an option that's in a further out cycle even if we're short an option in a near-term cycle that longer-term option will be more susceptible to price change in terms of implied volatility change so we're going to see a benefit if implied volatility increases on our overall spread and that's exactly what we want so you'll see us deploying these diagonal spreads whether it's

a poor man's covered call or a poor man's covered covered put in a low iv environment the second takeaway is that the key to adjusting is always going to be reducing our cost basis so if you've paid attention to any of the other adjustment strategies or other adjustment segments we had the key concept was reducing our cost basis and moving our strikes around to continually collect a credit whenever we can and reduce our cost basis further and further because we never know what's going to happen in the market in terms of directional moves but if

we can control what we know which is our cost basis then that's going to put us in a much better situation than if we did not do so and last but not least especially with poor man's covered calls and poor man's covered puts you're not going to see us adjusting that long option very much there's not really a reason to do so we can't do so without moving our max profit or moving on max loss or we can't really move that option for a credit so since our key is reducing cost basis and moving that

short option you're going to see the short option be the mobile one when we're looking at adjusting these sort of trades so in both of these scenarios we looked at moving our short strike up and out and when the stock price went against us we looked at moving our short strike closer to where the stock price was originally trading or even if we want to we can move it a little bit further down but it's really important to be cognizant of the price we paid so if i paid five dollars and i move my strike

closer to my long strike and i'm i'm now made a four dollar widespread even if the stock price comes back up i would see a loss unless i collected a dollar to offset that loss on the trade because if i've got a four dollar wide spread and i paid five dollars for it originally and i didn't collect that extra one dollar that i'm moving my strike closer to i'm gonna only be able to sell that spread out especially when i create it into a vertical spread i'd only be able to sell that spread for four

dollars and if i paid five dollars for it that's going to be a loss unless i collected a dollar somewhere in that role so it's really important to realize that the short option is mobile so thanks so much for tuning in hopefully you enjoyed that segment if you've got any questions or feedback shoot me an email here or follow me on twitter at do trader mike we've got jim schultz coming up though so stay tuned hey everyone thanks for watching our video if you liked this video give it a thumbs up or share it with

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