The nice thing about having a blog is it provides a venue to provide in-depth answers to questions that I may typically only be able to offer a brief response to.

Mark asked me to show how to build a poor boy’s covered call on Bank of America (BAC). I’ll provide a link to previous articles and shows I’ve done that elaborate on the strategy if you need a refresher.

Remember, the idea behind this strategy is to build a trade that walks and talks like a covered call but is much cheaper. Hence, a poor boy’s covered call.

The Long Call

The first order of business is buying a longer-term ITM call to serve as a substitute for buying stock. How many months you purchase depends on how long you’d like to keep selling calls against the stock. I prefer to use 4-month options because it keeps the cost minimal while still allowing me to sell anywhere from one to three months’ worth of options against it.

I’m going to buy a May call option.

The next decision is which strike price to buy. We need a higher delta so that the call behaves somewhat similar to a 100 share stock position. However, purchasing 100 delta calls is really expensive. In most cases buying a call with a delta around 0.75 or higher is sufficient.

I’m going to buy the May $32 call option, which has a delta of 0.73. It costs $3.70. Or only about 11% of what it would have cost to buy 100 shares of stock.

Rule #1: Buy a 4-month, 75+delta call option

The Short Call

Deciding which call to sell against your long option is simple. Just use the same rules you do for a traditional covered call. Usually, we sell a one-month 0.40 delta call. I’m fine with anything around 30 to 45 days with a delta between 0.30 and 0.40.

For BAC, I’m going to sell the Feb $36 call for 52 cents. Let’s review the trade stats:

Long May $32 call @ $3.70

Short Feb $36 call @ 52 cents

Net Debit/Max Risk: $3.18

Rule #2: Sell a one-month, 0.30 to 0.40 delta call

Risk Graph

Here’s a picture of the risk graph. Note how your profit maxes out at the short strike of $36. The best-case scenario is to have BAC sit at or above $36 come Feb expiration.

Trade Management

There are only two potential outcomes. Either the stock rises, and the short call moves ITM or the stock stagnates or drops, and the short call remains OTM. I divide my management thoughts into these two outcomes.

Short call moves ITM

If BAC rises past $36 pushing the short Feb $36 call ITM, then I typically ride close to expiration and then buy back the call to avoid being assigned when there is little to no time value. You can track the remaining time value by using the extrinsic value column heading in the option chain.

Upon buying back the call, you can decide whether you want to sell a new one-month call to keep the trade going or sell the long call and close the entire position.

Short call remains OTM

If BAC remains below $36, the short Feb $36 call will dwindle in value toward zero. You can either ride to expiration and let it expire worthless, or input a buy limit order around 5 cents to exit when you’ve captured the bulk of your profit.

The primary risk is if the stock falls too far. If it does, most traders would close out the entire trade on a break of major support. You can model what the loss would be by using the risk graph.

I’ve cut a video walking through how to build the trade below.

Two final questions from Mark B.

First: Is BAC a good pick for poor boy’s covered calls?

My answer: Sure. It’s good in the sense that it has great options liquidity (tight bid-ask spreads) and is easy to build trades on. It’s good because it currently sits in an uptrend and looks mildly bullish. It’s also good because it’s a large-cap and not prone to massive swings. Finally, it’s good because it has lower implied volatility. That said, I obviously don’t know if BAC will end up rising or falling from here, so as with any trade there is risk. But, that risk is less than if you did this on some high flying, volatile stock.

Second: Is the Tackle 25 list good to do poor boy’s covered calls or only covered calls?

My answer: You can do both. Whether you do a poor boy’s or a traditional covered call probably depends in large part on how big your account is and how much you want to tie up in stock.

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