Covered calls are a popular way to generate an income from stock options, but they require a potentially large upfront investment in the underlying stock. While such an investment isn’t a problem for large account holders, it can be prohibitively expensive for those just getting started using options to generate income. Fortunately, there are some alternative strategies that investors can use to create an income with options.
Let’s look at a popular alternative to covered calls that doesn’t require an upfront investment in the underlying stock.
Lowering the Cost of a Covered Call
Covered calls can be extremely costly, depending on the price of the underlying stock. For example, the cost to initiate a covered call on a $250 per share stock is $25,000! While many investors use covered calls to supplement their existing long stock holdings, those using covered calls for income generation may find these costs too high. Single, large investments can prohibit proper diversification for small accounts.
Diagonal debit spreads, also known as “poor man’s covered calls,” provide option income without the upfront investment of a covered call. In smaller accounts, it’s a great way to generate income like covered calls with less capital and risk. The downside is that it’s a bit more complex and challenging to manage, making it ideal for intermediate options traders.
Diagonal Spread Option Diagram – Source: Quantinsti
The strategy is a “diagonal” spread because the two options have different expiration dates and prices, meaning they’re located diagonally on an options chain. It’s also a “debit” strategy because the two options create a net debit, meaning that you’ll have to pay money to establish the position at the onset. Fortunately, the debit is less than the upfront cost of purchasing shares in a covered call trade.
The strategy has two steps:
- Buy an in-the-money call option with a long-term expiration.
- Sell an out-of-the-money call option with a near-term expiration.
The in-the-money call option substitutes for the long stock position since you can exercise it to deliver stock if the out-of-the-money call option goes in the money. In addition, the net premium paid for the in-the-money call option is a fraction of the cost of acquiring the underlying stock, making it a more cost-effective option for income investors.
The poor man’s covered call has too many variables to calculate a specific maximum profit or breakeven point, but there are a few ways to make reasonably accurate estimates:
- The max profit is approximately equal to the difference between the call strike prices minus the debit paid to enter the position.
- The breakeven point is roughly equivalent to the long call strike price plus the net debit paid to enter the trade.
- The max loss is equal to the total net debit paid to enter into the position.
Once the short call option expires, you can keep the premium and either sell the long call or write another call option to generate more income.
Tips for Trading Poor Man’s Covered Calls
The key to success with a poor man’s covered call is selecting the correct options and adequately managing the trades over time.
Some quintessential tips to keep in mind include:
- Choose stocks that have low or decreasing implied volatility (e.g., a low beta). Avoid companies that have near-term earnings reports or other events that could increase volatility.
- Choose long in-the-money call options with an extrinsic value equal to or lower than that of the short option. The deeper in the money, the easier it will be to find opportunities. The trade-off is that deep-in-the-money call options will be more costly.
- Ensure that the total debit paid isn’t more than three-quarters of the difference between the strike prices. That way, you’re leaving adequate room for upside.
If the stock price moves significantly higher, you may want to close the trade as there’s less profit potential since the options are trading closer to their intrinsic value. Conversely, if the stock price moves lower, roll the short call to a lower strike price to collect more credit and offset losses or consider closing out the position to cut losses.
Keep in mind that the absolute profit isn’t as high as covered calls, but the return on investment can be much higher. The poor man’s covered call also has limited upside potential, just like a covered call. If the underlying stock moves sharply higher, both strategies will only benefit from a portion of the total gains up until the short call’s strike price.
Alternative Strategies to Consider
Any option strategy that generates a net credit can create an income. While the poor man’s covered call is a popular covered call alternative, there are many other strategies that investors may want to keep in mind.
Some similar strategies include:
- Cash-secured puts involve selling a put option while setting aside cash to buy the stock in the case of assignment. If the option isn’t assigned, you keep the premium payments as income.
- Credit spreads involve buying one option and selling another option at a net credit. Vertical spreads have different strike prices, calendar spreads have different expiration dates, and diagonal spreads have different strike prices and expiration dates.
You may also want to consider classic covered call options. Using the Snider Investment Method, you can create a steady income from your portfolio and ensure cash flow in retirement using a combination of stocks, options, and cash, along with a specific technique applied in a particular sequence to maximize your portfolio’s income potential.
The Bottom Line
Covered call options are one of the most popular ways to generate income from options. However, while it’s relatively low risk, the strategy can have a high upfront cost, depending on the underlying stock price. Long-term investors may not mind, but those using covered calls to generate an income may want to consider alternatives.
The poor man’s covered call, or diagonal debit spread, lowers upfront costs by replacing a long stock position with a long in-the-money call option to deliver the stock if needed. The lower upfront cost makes it easier for smaller accounts to generate income while potentially leveraging returns and lower risks.
At Snider Advisors, we don’t recommend buying options or get into the more complex option strategies like a poor man’s covered call. Instead, we designed the Snider Investment Method. It is a specific strategy that makes it easy to identify good covered calls and manage trades in a way that maximizes income and lowers risk for investors nearing or entering retirement. Take our free e-course or inquire about our asset management services.