Making Regular Income with the Poor Man's Covered Call (Diagonal calendar spread, leveraged covered call, synthetic covered call, fig leaf)

This strategy is known by several names as noted in the title. It is most commonly known as the Poor Man's Covered Call (PMCC), which is a type of calendar spread. This strategy presents an opportunity to sell covered calls when you cannot or do not want to own 100 shares of the underlying. This carries the additional risk of gamma kicking your ass, which we will address below. Used correctly, however, the PMCC offers a fantastic opportunity to turn even modest amounts of capital into a stream of income.

tl;dr: Buy a deep ITM LEAP at a delta of at least 0.60, preferably closer to 0.80; this will cost you significantly less than the cost of 100 shares and can still be used as collateral against a short call. Using the LEAP as collateral, sell short-term calls at no more than the 0.3 delta unless you are bearish in the near term. This will grant you a premium every expiration date that your short call expires worthless, turning your LEAP into a driver of income. The additional risk is due to gamma exposure. If the underlying rockets higher, it will put the delta on your short call close to 1.00, resulting in the potential for an overall loss. Avoid assignment by rolling your short calls that are about to expire ITM.

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What is a Poor Man's Covered Call?

The PMCC is an alternative to covered calls for people who cannot afford or do not want to own 100 shares of the underlying. For example, to write covered calls on SPY right now, you would need about $29,000. However, you can do a PMCC for less than $6,000. There are some disadvantages to the PMCC versus just selling covered calls, but the reduced cost of entry is usually worth the risk. We will address this more later.

PMCCs are created with the following positions:

1) Buy an ITM LEAP expiring at least 6 months out with a delta of at least 0.60, preferably higher if you can afford it.
2) Sell an OTM short-term call with a delta of no more than 0.25.

The PMCC is a calendar spread, meaning you have two different expiration dates. This strategy benefits from theta decay. That is, the short term call that you sold will lose value very quickly compared to your LEAP which does not expire for many months. As you sell short term calls using your LEAP as collateral, you are likely to see most of those short calls expiring worthless, letting you keep the premium as cash each expiration day. Meanwhile, your LEAP will lose very little value to theta decay, giving you a very high net profit.

How do we set strikes on a PMCC?

Step 1 is to spend money to buy a LEAP. Step 2 is to sell a call expiring much sooner than the LEAP. That way, we can sell many calls over the life of the LEAP.

LEAP: It is important that the delta on the LEAP is high, preferably above 0.80, meaning the strike is set relatively deep ITM. That way, we can pull as much benefit as possible from increases in the stock's price. If our delta is too low, such as 0.30, then our LEAP will only increase by $30 for every $1 of stock price increase, as opposed to $100 if we held 100 shares and were writing proper calls. Not only does this mean missing out on gains, but it cal also cause issues with gamma, which we will discuss in the risk section.

Short Call: Likewise, we want to sell covered calls with a delta no higher than 0.25 unless we are bearish in the short term. If you are setting your strikes correctly, your short calls should almost always be at least 2 strikes OTM. Remember, we want our short calls to expire worthless, so we don't want to sell strikes too close to the market price. If the delta on our short call is higher than the delta on our LEAP, we are losing money as the stock price rises. This is a huge risk if the stock rises quickly past our short call, so hedge your bets and sell short strikes OTM.

What is the risk versus a regular covered call?

There are a couple notable risks versus just owning 100 shares and selling regular old covered calls:

1) Gamma risk is the main risk of PMCCs. Gamma is the Greek that tracks the change in delta for every dollar of change in the underlying's stock price (delta is the change in an option's value for every dollar of change in the underlying's price, if you didn't know).

In short: if the stock price rises too fast past your short call's strike, gamma will kick your ass by driving the short call's delta above your LEAP's delta. This will result in a loss for each further dollar of increase in the underlying's price.

Detailed: As stated above, we are typically buying LEAPs at the 0.80 delta, which means for every dollar of change in the underlying's value, the LEAP will move by about $80. The gamma on LEAPs is very low, typically about 0.004 and lower. As a result, the delta on a LEAP will barely move. If you buy the 0.8 delta, that's basically what you get no matter what happens to the underlying unless it absolutely moons or tanks.

This contrasts sharply with the gamma on the short call. Once your short call winds up even a few pennies ITM, gamma regularly breaks 0.3. By the time you are 3%+ ITM, gamma will likely be above 0.5, and delta will probably already be above 0.4 by then. As a result, if your short call winds up more than 2-3% ITM, delta will be pretty darn close to 1.0. For every dollar of further gain in the underlying, you are losing $100 on that short call. Meanwhile, you LEAP, unaffected by gamma, will only be gaining $80. This will give you a net loss of $20 for each further increase in stock price.

2) Volatility risk is the second risk factor. Vega is the Greek (even though it is not actually a Greek letter) that tracks how an option's price will change for every 1% change in implied volatility. For a contract with a vega of 0.10 and implied volatility of 22%, for example, the contract will rise or fall by $10 if IV were to go up to 23% or down to 21% respectively.

In short: If IV drops dramatically, it will barely affect the price of your short call since vega on short-term contracts is very low. However, a big drop in IV will crush the value of your LEAP since the vega on LEAPs is very high. This will cause a net loss, if all other factors stay the same.

Detailed: Implied volatility on short term contracts is very low. For example, an ATM SPY call has a vega of 0.07 on the day of expiration. If IV drops, the contract does not care. Delta, gamma, and theta are the Greeks that matter on short term contracts, not vega. This contrasts with the vega on LEAPs. The $250 SPY LEAP expiring Dec. 2022 has a vega of 1.57 on IV of 22% as of April 29, 2020. 

If IV were to drop by 1%, that LEAP will lose $157. Meanwhile, the short call will only lose $7. The net loss on just a drop in IV, other factors being equal, is $150. Luckily, as stocks tank, IV tends to rise, which means vega will help ice the wound if the stock drops quickly. On the other hand, IV tends to drop when stocks rise, so vega will eat into your gains ever so slightly as your LEAP goes deeper ITM (note: SPY has to gain about $20 before you see a 1% drop in IV, so it is not as though vega will beat you down when your LEAP gets deeper ITM; delta will more than offset the reduced IV).

3) Wide bid/ask spreads are notorious among LEAPs since volume is relatively low. If you buy with a market, you are liable to start the position down a few hundred dollars above the next highest bid. ALWAYS use limit orders to buy LEAPs and try to split the bid/ask spread to something reasonably by buying in between them.

Can we do one together?

Let's. Here is the current picture on SPY LEAPs as of April 29, 2020:

The SPY $250 LEAP expiring Dec. 2022 is over $41 ITM and is trading for about $5,900. The delta is 0.71, so it is within the range we target. If we go long this contract, we have a contract for up to 32 months that we can use as collateral to sell calls against. And it will cost us less than $6,000 as opposed to the $29,173 it would cost us to write regular covered calls.

Now, here is the picture for the SPY $298 call expiring May 11 (two weeks out):

The delta is less than 0.30, so we are in our target zone. We are also about 3% OTM, so that also suits are risk tolerance.

If we were to sell this contract, we would get about $215 in premium on the spot. 

Let's talk through how this might turn out on May 11.

1) SPY drops to $290 from its current price of $291.70. Our LEAP loses $120 (0.71 delta times $1.70 drop in value). We keep the whole $215 premium from the short call and sell a new covered call.

2) SPY rises to $289. Our LEAP gains about $518. Out short call expires worthless, so we keep the whole $215 premium.

3) SPY goes to $310. Our leap gains about $1,300. Our short call expires $12 ITM and is now worth $1,200. We lose $985 on the short call and miss out on most of the SPY gains since the short call dug deep into our profits from the LEAP. SPY ran away without us.

4) Recession cancelled. SPY flies to $350. We fucked. Our LEAP will have risen by $4,260. Our short call will be $52 ITM for a $5,085 loss. We will have lost $825. Could be worse, but still sucks. This may be an opportunity to roll the short call to a later date and a higher strike price.

Where can I find more information?

Options playbook has a section on this, although it calls it a fig leaf, for some reason.
TastyTrade, as always, has a wide section on the strategy.

Summary

Poor Man's Covered Calls present a great opportunity to write covered calls when you cannot afford or do not want to hold 100 shares of the underlying. The goal of the strategy is to use your LEAP as collateral to continuously sell premium on short call FDs. Take the time and put up the capital to ensure your strikes are adequate to give you a delta of at least 0.60 on the LEAP and less than 0.30 on the short call. Keep in mind that Robinhood will not recognize this strategy by name, so double check to ensure you are setting it correctly.

Disclosure

This post summarizes Mikey's observations in employing the poor man's covered call strategy. Mikey is currently using PMCCs on 12/2022 SPY $250c and 9/2020 T $26c. The PMCC is an advanced strategy that is not suitable for traders with no prior experience. Consider consulting a financial advisor if you are not confident in your own ability.