June 30th, 2022

Covered Call Income For Less

The continued sell-off this year has hit some big names of the SP500 particularly hard.  Stocks like Amazon (AMZN), Adobe (ADBE), and Boeing (BA), to name a few, are all down more than 30% in the first half of the year.  Volatility remains high, so now may be the right time to implement an options strategy that allows you to collect a premium on the shares you own.  

Selling covered calls for income is a fairly known strategy in which case you sell the right to purchase your shares of an underlying stock at a certain price and date in exchange for cash upfront.  If the stock is at or under the strike price you sold at the date of expiration, you as the options seller will keep the premium you collected as well as the shares.  

What if you have a smaller account and don’t own 100 shares of Adobe (ADBE), which is currently trading at $368.50 a share?  To sell a covered call of Adobe, you’d need $36,850.  

There’s still a way you can sell covered calls without owning the shares!  That’s right, for a fraction of the cost of owning the shares, you can still collect the same premium each week or each month with this covered call trading strategy.  

It’s called the poor man’s covered call.  Keep reading to find out more about this strategy.  

While a traditional covered call uses long shares for bullish exposure, a poor man’s covered call uses a long call.  

A standard covered call works by purchasing 100 shares and then selling an out-of-the-money (OTM) front-month call against it, typically at a higher price.  

The poor man’s covered call (PMCC) works by purchasing a deep-in-the-money (ITM) back-month call and then selling an OTM front-month call.

Going back to my Adobe (ADBE) which dropped from $699.54 to a current price of $368.50 in six months.  

Let’s assume that you have a reason to be bullish and you’re assuming that you are interested in Adobe because you can now get in at a 40%+ discount compared to 6 months ago.  Since market volatility is still high, you want to take advantage of the heightened option premium, and look at writing options for income.   

 

First, I’m going to look for a long option 90+ days away.  The further out you go for expiration dates, you may not have as many options to choose from.  For example, Adobe has weekly options, but going out around 90 days, I have the ability to trade 16 Sept 22 options (79 days away) or 21 Oct 22 (114 days away).  The weekly options haven’t been created yet.

 

Let’s use the October expiration.  Now, I’m going to look for a strike price with a delta around 0.70.  Remember, we’re looking for in-the-money options to buy.  The 21 Oct 22 $330 strike price is going for $59.08 (or $5908 per contract).  

 

Now it’s time to sell calls against it for income.  This really depends on the user and I know many of you are experienced options sellers already. 

 

When I sell covered calls, I like to make sure I’m selling something far enough away that I can still have capital appreciation on the bullish exposure.  I may look to sell a call around 0.15 delta.  In this example, you can sell an 8 July 22 $$390 weekly call and collect $2.04 ($204) per contract and do that week after week.  

 

Others may prefer to go out longer in time and collect more premium by selling something closer to the current stock price and managing the trade over time instead, either by rolling or resetting the trade.  

 

Ignoring the 15 July 22 expiration since it’s only 16 days away, there are 2 monthly cycles before October.  Let’s say you want to sell options during the monthly expiration cycle.  Let’s look at the 19 Aug 22 options.

 

You can sell a 19 Aug 22 $370 at-the-money call for $22.75 ($2275) per contract.  As time passes, you benefit from theta decay and you can choose to roll your sold contract each month.  

 

What if you don’t want to roll?  That’s ok too.  

 

Let’s take a look at this example trade.

Ticker: ADBE

Current price: $368.50

Buy to open 21 Oct 22 $330 call

Sell to open 19 Aug 22 $370 call

Total debit (max risk): $36.33 ($3633)

Break-even stock price: $348.05

 

At expiration (19 Aug 22), your risk graph looks like this with your max profit being $1539 per contract if Adobe stays around $370.  Even if Adobe goes all the way up to $440/share, you’d still make $650/contract.  Remember, you can still sell monthly calls two more times if you’d like, or just close out of the position and move on.  As long as ADBE stays above $348.05 by the 19th of August 22, you will have a winning trade.

While $3633 is still quite a bit of money, it’s far less than the $36,850 you’d need to buy 100 shares.  And the premium you collect each month (or each week) for the option you sell is the same, whether you own 100 shares or you own 1 deep-in-the-money call option.

 

There is a trade-off between owning 100 shares and owning a call option.  The long call option can lose value over time if there isn’t a move to the upside.  The short call option will decrease value faster, which results in a profit, but you are subject to volatility and time risk more than you would be by purchasing 100 shares.  

 

If you have any questions, comments, or anything we can help with, reach us at any time.

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Guest Writer, Filthy Rich, Dirt Poor

Editor, Wealthy Investor Society