Managing a Poor Man's Covered Call Trade When Share Price Drops Below the LEAPS' Strike

10/19/2020 10:00 am EST

Focus: OPTIONS

Alan Ellman

President, The Blue Collar Investor Corp.

A typical Poor Man’s Covered Call (PMCC) trade involves buying a deep in-the-money call LEAPS option and selling short-term out-of-the-money call options, which is protected by the long LEAPS position, states Alan Ellman of The Blue Collar Investor.

In April 2020, Martin shared with me a PMCC trade he executed with PPL Corp. (PPL) where share price declined below the LEAPS' strike during the coronavirus crisis of 2020. This article will evaluate the initial trade set-up and management opportunities.

Martin’s PMCC trade initiation

  • 2/20/2020: PPL trading at $35.42
  • 2/20/2020: Buy the $30.00 LEAPS 1/15/2021 call for $5.70
  • 2/20/2020: Sell the 3/20/2020 $36.00 call for $0.30

BCI PMCC Calculator: Initial Trade Tab

PPL: Initial Trade Calculations
PPL: Initial Trade Calculations

The initial trade formula is satisfied:

  • Difference between the strikes + initial short call premium > cost of LEAPS
  • ($36.00 – $30.00) + $0.30 > $5.70
  • The initial time-value return on the short call is 5.26%
  • The initial upside potential is 10.18%

Price Chart of PPL During the Coronavirus Crisis

PPL Price Chart as of 4/9/2020
PPL Price Chart as of 4/9/2020

Share price dropped below the LEAPS $30.00 strike and was at $26.70 on 4/9/2020. Keep in mind that the original short call expired on 3/20/2020.

Exit Strategy Choices

We must first decide if our bullish assessment of the stock changed. In this case, it is fair to conclude that the stock price declined as a result of the overall market downturn. If we determine that the issue was company-related, we close both positions, take a loss, and move on. In this case, we view this scenario as a price gap-down that was market-related and we roll-down to out-of-the-money strikes. This will allow us to generate additional time-value premium while, at the same time, allow for some share price recovery. Between 2/20/2020 and 3/20/2020 there were multiple opportunities to roll-down and once the March contracts expired, we can continue to write out-of-the-money short calls as share price recovered.

Discussion

When implementing the PMCC, we must first make sure the trade initialization formula is achieved. This now moves us into position management mode as with traditional covered-call writing. The active leg of the trade is the short call. Our entire arsenal of exit strategies is available including our 20%/10% guidelines.

Learn more about Alan Ellman on the Blue Collar Investor Website.

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