Bonus Chapter: How to Trade a Small Account and Boost Covered Call Returns

Since my book's publication, many readers have written in to ask me if there is a way to use the
covered calls strategy in a small trading account. Other readers have asked for a way to boost
the returns offered by covered calls.

It turns out that both questions have the same answer-- what is frequently called "the poor man's
covered call."

Don't be put off by the name!

As you will see, properly deployed, this strategy could be better described as "the rich man's
covered call."

It is a simple variation of the covered call strategy that you learned in Covered Calls Made Easy.

The only difference is that, instead of purchasing the underlying stock of the company, you
buy long-dated, deep-in-the-money call options (or "LEAP's").

Let me explain.

In the example in my book, we bought 1,000 shares of KO at 40.94, which cost us $40,944.95
including commissions.

In the poor man's covered call strategy, instead of buying 1000 shares of KO, you buy 10 call
options, with a strike price that is about 10% below where the stock is currently trading. So, if
KO is at 40.94, I would look for a strike price below 36.84 (40.94*.90=36.84).

If you have access to option Greeks data, the call option should have a delta that is somewhere
between 0.95 and 1.00. You also want to make sure that you pick a strike price where the bid-
ask spread is not too wide (usually no more than about 0.10 to 0.20). You also want to pick a
strike price that trades a decent amount of daily volume.

But if you just pick a strike price that is 10% or more below the current price of the stock, you
will do fine.

I could have chosen the 36.00 strike, but decided instead to pick the 35.00 strike. It is a big
round number, and so has a tighter bid-ask spread and higher daily volume. Its delta is about .97,
which means that it will move up $0.97 for every $1.00 that the stock moves up (and vice versa
on the downside).

I chose the 35.00 strike and decided to pick the January 20, 2016 as my expiration date. You can
see these options here:

http://finance.yahoo.com/q/op?s=KO&date=1452816000
These options are bid at 6.45 and offered at 6.60. I would like to get my order filled
immediately, so I will buy 10 calls at the 6.60 offer. This costs me (10 x 100 x 6.60) or $6,600
not counting commission. Commission is $11.45, so my total cost is $6,611.45.

If you only have $1,000 in your account, you could buy just 1 call option, and still have the same
potential high return that we discuss below.

These are long-dated call options (they expire in 8 months from today). If their expiration date
were 12 months or more in the future, nothing would change but they would be called "LEAPS"
(short for "Long-Term Equity Anticipation Securities"), which you may have heard of.

Now that I am long 10 call options with a strike price of 35.00, I sell 10 calls that expire in 1
month, and whose strike price is just above where the stock is currently trading (in the book, we
used the June 41.00 calls). As mentioned in the book, I collect $558.55 in premium after
commissions.

Now let's look at what this does to our returns.

We have collected $558.55 and only put up capital of $6,611.45. That is a one-month return of
558.55/6611.45, or 8.4%. If you can do this every month, you will have an annual return of just
over 100%.

In our regular covered call example in the book, our potential one-month return was only
1.36%. So by using poor man covered calls, we have effectively increased our potential return
by over 6x.

So what are the risks?

What if KO is trading at 100 near expiration? In that case, your short call position will be worth
10*100*(100.00-41.00), or -$59,000! But don't worry, because your long call position is worth
10*100*(100.00-35.00) or $65,000. So your net position is worth $6,000. And you still have the
cash premium of $558.55 that you collected. If you had traded out of your long call position
earlier, you would not have lost as much money to time decay (more on that below).

If KO is trading at or below 35.00 (the strike price) on January 20,2016, you will lose all of the
money that you invested in the January 35 calls-- because they will expire worthless. You will,
of course, still get to keep the $558.55 in premium.

If KO is at 36.00 when the January calls expire, they will be worth 1.00 (36.00-35.00) near
expiration, or $1,000 for the 10 calls.

If KO is at 37.00 when the January calls expire, they will be worth 2.00 (37.00-35.00) near
expiration, or $2,000 for the 10 calls.

And so on.
If KO is at 41.60 when the January calls expire, they will be worth 6.60 (41.60-35.00) near
expiration, which is exactly what you paid for them!

Remember to always trade out of your long call position well before expiration! Some
brokerages will automatically exercise deep in-the-money call options, and you will end up
buying the stock at 35.00 (and will need $35,000 in your account to do so!).

After the June short call position expires, you can always try to trade out of your long January
call position right away. Even if they have declined a little, you have still done well, since you
get to keep the $558.55

The January 35 calls will slowly lose value over time, due to time decay. At first, this will be so
slow that it is imperceptible. But beginning about 60 days before expiration (November 20,
2015), the January 35 calls will lose value more rapidly. By that point, you will need to have
exited them completely.

When you sell the January 35 calls, you can also immediately buy the June 2016 35.00 calls, or
even the January 2017 35.00 calls, and then continue to sell shorter-dated call options against
those positions.

As you can see, poor man's covered calls are an extremely powerful and flexible addition to your
covered calls "tool box."

In addition to boosting returns and allowing smaller accounts to get in on the game, poor man's
covered calls are also an excellent way to diversify a larger account.

For example, rather than just having one or two regular covered call positions in a $20,000
account, you could spread your risk over 10-20 different poor man's covered call positions.

Questions, or comments?

Please write to me at matt@trader.university