Which Strike to Choose? A Deep-Dive into Poor Man’s Covered Calls

poor-mans-covered-calls-strikes

One of my favorite strategies is the long call diagonal debit spread, otherwise known as a poor man’s covered call.

The strategy’s name comes from the reduced risk and, in most cases, significant lower capital requirement when compared to that of a classic covered call. Essentially you can create the same equity position as a covered call, but for a fraction of the cost.

The reason is simple, we are using a stock alternative known as a LEAPS (Long-Term Equity Anticipation Security) contract. LEAPS are typically long-term options with at least 1 year until they are due to expire.

For example, as seen below in the options chain for the highly liquid SPDR S&P 500 ETF (SPY), there are six expiration cycles that qualify as containing LEAPS contracts.

LEAPS-call-strikes-SPY

Which leads to the question I am most often asked about poor man’s covered calls, “which long-term options (LEAPS) should I buy?”

To answer this question, let’s take a look at a strike of SPY with an 0.80 delta in three of the expiration cycles above, the December 16, 2022 expiration with 394 days left until expiration, the June 16, 2023 expiration cycle with 576 days left until expiration and the January 19, 2024 with 793 days left until expiration.

Once we compare the 0.80 delta call strike over various expiration cycles, I then want to do a quick comparison using the same call strike, regardless of delta. This should give us some great insights into how we want to approach purchasing a LEAPS contracts based on our investment goals. Some may wish to hold a LEAPS position for a month, collect premium by selling short-term calls against the LEAPS position and move on to another equity. Some may wish to hold a diversified group of equities over the intermediate to long term. I take this approach quite frequently with a variety of portfolios (All-Weather, etc.). I might hold 5 to 10 positions and continually sell calls against my LEAPS. I’m spending less capital for the equity, reducing risk by lowering my cost basis each time I sell a call and given the ability to make a return that tends to be 3 to 5 times the return of the actual equity. And unless we see a significant and quick drop in our position, we have the ability to make a return even if the stock pushes lower. I’ve been successfully using this approach for over two decades now, in a variety of different ways, and it remain one of my bread-and-butter strategies until my trading days have passed. The flexibility and control the strategy offers is why we love options.

Price of SPY: 468.00

Price of SPY December 17, 2021 (30 days left until expiration) call option (30 days): $2.87

This is our short call and will remain consistent for each of the examples. It represents a great depiction as to what selling premium on SPY will look like every 30 days.

poor-mans-covered-calls-LEAPS-SPY

December 16, 2022 (394 days left until expiration)

The Dec22 380 calls have a delta of 0.80. All things remaining equal, this means that for every $1 move in the underlying, in this case SPY, the price of the call option will move by roughly $0.80 per contract.

You can also think about the delta of 0.80 as owning 80 shares of SPY since the price movement of the call option will be equivalent to 80% of the underlying equity.

The price of the LEAPS contract is $100.75. The probability of touch sits at 53.74%.

LEAPS-poor-mans-covered-calls-december

June 16, 2023 (576 days left until expiration)

Like the Dec22 380 calls above, the Jun23 365 calls have a delta of 0.80. All things remaining equal, this means that for every $1 move in the underlying, in this case SPY, the price of the call option will move by roughly $0.80 per contract.

You can also think about the delta of 0.80 as owning 80 shares of SPY since the price movement of the call option will be equivalent to 80% of the underlying equity.

The price of the LEAPS contract is $118.10. The probability of touch sits at 56.33%.

oor-mans-covered-calls-leaps-june

The Jun23 380 calls have a delta of 0.77. All things remaining equal, this means that for every $1 move in the underlying, in this case SPY, the price of the call option will move by roughly $0.77 per contract.

You can also think about the delta of 0.77 as owning 77 shares of SPY since the price movement of the call option will be equivalent to 77% of the underlying equity.

The price of the LEAPS contract is $106.50. The probability of touch sits at 61.71%.

poor-mans-covered-calls-leaps-june-spy

January 19, 2024 (793 days left until expiration)

Like the Dec22 380 calls and Jun23 365, the Jan24 350 calls have a delta of 0.80. All things remaining equal, this means that for every $1 move in the underlying, in this case SPY, the price of the call option will move by roughly $0.80 per contract.

You can also think about the delta of 0.80 as owning 80 shares of SPY since the price movement of the call option will be equivalent to 80% of the underlying equity.

The price of the LEAPS contract is $134.55. The probability of touch sits at 57.86%.

poor-mans-covered-calls-LEAPS-SPY-january

The Jan24 380 calls have a delta of 0.75. All things remaining equal, this means that for every $1 move in the underlying, in this case SPY, the price of the call option will move by roughly $0.75 per contract.

You can also think about the delta of 0.75 as owning 75 shares of SPY since the price movement of the call option will be equivalent to 75% of the underlying equity.

The price of the LEAPS contract is $112.50. The probability of touch sits at 68.12%.

poor-mans-covered-calls-LEAPS-S&P500-SPY

You can see all the stats in the spreadsheet below.

leaps-poor-mans-covered-calls-comparison

Summary

Basically, what I glean from all the info above is, if you want to make a quick 30-to-60-day trade, going with a shorter duration LEAPS contract is sufficient. It requires far less capital which allows you to diversify to a much greater degree given the same amount of capital.

Going with a shorter duration LEAPS contract has its limitations though. It requires considerably more trading and gives you far less time to recover if the price of your underlying, in this case SPY, moves significantly against you.

However, if I plan on holding my positions for a greater length of time. Say 6, 12, 18 months or longer like I do in my All-Weather portfolio, Dogs of the Dow portfolio and numerous others, then my preference is to go out further in time with the LEAPS I purchase.

By taking this approach, I’m spending more capital, but I can also sleep better at night. I’m also more inclined to stick with my delta approach as it gives me more of a cushion than the strike price approach. And overall, the deltas aren’t that different. Yes, the cost is greater, but again, I’m happy with an approach that allows me to make 3 to 5 times more than the underlying stock or ETF.

There are so many different approaches that one can take given the information above. I would love to hear what all of you have to say. How do you use LEAPS? What is your preferred approach?

As I’ve stated numerous times over the past few months, I plan on releasing videos that cover much of what I’ve discussed over the past five months or so. Plus, much, much more.

Again, if you have any questions, please feel free to email me or post your question in the comments section below. And don’t forget to sign up for my Free Weekly Newsletter for weekly education, research and trade ideas.

5 comments on “Which Strike to Choose? A Deep-Dive into Poor Man’s Covered Calls

  1. Steve on

    I love poor man’s covered calls. However, if the underlying stock goes down, the highly leveraged long call can quickly lose significant value. Therefore, I only like to use the strategy on stocks in an up trend. If the stock is oversold, I like to sell 0.4 Delta covered calls to allow for stock appreciation and if it is overbought, I sell 0.2 delta covered calls in case there is a pullback. Also, if the underlying stock goes up quickly through the short dated sold call, you have to be sure to buy the short call back before expiration to avoid being forced to buy the 100 shares of stock being called away from you.

    Reply
    • Andy Crowder on

      Thanks for sharing Steve. Maintaining proper position-size is really the best way to manage risk. Understanding risk is truly the key to long-term success. Thanks for sharing your experience with poor man’s covered calls.

      Reply
  2. Jason Levy on

    It’s a great strategy. I have been doing it for a few years myself. As a test, about 18 months ago I opened a separate account and put $x into it. I call it the “snowball fund”. The premium I collect on the short calls pile up, then I buy another LEAP. I started with 8 LEAPS and have 13 now. At some point, I will need to roll these LEAPS further out, but they are .96 delta or so now (they started at .80). The account is up 260% within 18 months and I believe the overall risk is minimal since I am using ETF’s for the LEAPS. I do not plan on touching this for 10 years. Let’s see what happens…

    Reply
    • Andy Crowder on

      Jason,

      Nice work! Just make sure you have some risk-management in place. We’ve seen market that is perfect for bullish strategies so understand that your results are best case scenario…and that’s awesome! But, you want to keep those gains intact, so maintaining some risk-management techniques is always helpful. Good luck and I hope you will continue to share your results. Thanks again for the kind words.!

      Reply

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