Should poor men be leveraged?

Backtest Notebooks

Everybody loves a covered call.

First you start with the belief that they’re a magic bean tree that produces equity returns and income boosts. Pretty soon you fall down a rabbit hole where you’re micro-analyzing the daily PnL components. Or bending your strategy to extract maximum distributions.

There’s plenty of flexibility to this trade, and even with just delta and days to expiration as your parameters, you can mold it to a number of different objectives. And with hundreds of liquid tickers to trade in, there’s even more potential opportunities.

If the regular trade isn’t enough for you, there are ways to spice it up. While I think the name could use a revamp, the “Poor Man’s Covered Call” (PMCC) can be a clever strategy that allows you to add leverage by substituting the stock position for a deep in the money option.

Instead of owning the shares and selling calls, the PMCC strategy looks like a big call spread. The “poor” aspect comes from the fact that if you can’t afford a round lot, perhaps you can afford an ITM option that will act like one.

The cost of this leverage is some tail risk. Long equity can go to zero, but a long call will go to zero a lot sooner. If stock is trading at $200, while you save money buying the $160 call, if spot falls below there you’re out all the capital, compared to the regular covered call trader who’s down “only” 20%.

Introducing new parameters to a strategy necessarily adds complexity. Compared to a regular covered call you have double the deltas and days to expiration to choose, and replacing stock with options also brings along greek exposure. The deeper the ITM call delta, the less that matters, but stock prices have a way of moving to leave your exposure out there.

There’s also no requirement for these options to be in the same expiration. Selecting a further back month call and selling shorter dated overlays will reduce transaction costs of getting in and out of a spread. The flip side is you have to pick a lower strike option (and thus more capital) to get the most stock-like exposure.

Today in the Backtest Notebooks, we’ll look at just how leveraged you can afford to be with this strategy.