Using a Poor Man’s Covered Call in the Gold Miners

Most of us have used, or at least heard about, covered calls.
Buy a stock, sell calls against it.
It’s an easy strategy to implement, but the problem, at least for some, comes down to capital. You must have at least 100 shares of stock to sell a call. For some, acquiring 100 shares just isn’t affordable. Others prefer not to up tie up working capital toward 100 or more shares of stock.
There is an alternative to a covered-call strategy. And it’s a good one. In the options world the strategy is referred to as a poor man’s covered call.
A poor man’s covered call is similar to a traditional covered-call strategy, with one exception in the mechanics. Rather than buying 100 or more shares of stock, an investor simply buys an in-the-money LEAPS call and sells a near-term out-of-the-money call against it.
LEAPS, or long-term equity anticipation securities, are basically options contracts with an expiration date longer than one year. LEAPS are no different than short-term options, but the longer duration offered through a LEAPS contract gives an investor the opportunity for long-term exposure.
Other than reducing the capital required, the reason we purchase LEAPS is to minimize the extrinsic value and theta decay. Basically, a poor man’s covered call is viewed as a diagonal trade with a significantly longer duration.

How I Approach a Poor Man’s Covered Call

First of all, I always start – just like when I use a traditional covered-call strategy – by choosing a stock or ETF that I am comfortable owning for the long term. This is a crucial first step.
Take, for instance, the Vaneck Vectors Gold Miners (NYSEArca: GDX)
The ETF exemplifies the typical characteristics that I look for when using a poor man’s covered-call strategy.
 
The next step is to choose an appropriate LEAPS contract to replace buying 100 shares of GDX.
If we were to buy GDX shares at $23.49 per share, our capital requirement would be a minimum of $23.49 plus commissions ($23.49 times 100 shares).
If we look at GDX’s option chain, we will quickly notice that the expiration cycle with the longest duration is the January 2018 cycle, which has roughly 463 days left until expiration.
With the stock trading at $23.49, I prefer to buy a contract that is in the money at least 10%, if not more. For the options geeks out there, I like to buy a LEAPS contract with a delta of around 0.80. Let’s use the $17 strike for our example.
We can buy one options contract, which is equivalent to 100 shares of GDX, for roughly $8.20, if not cheaper. Remember, always use a limit order – never buy at the ask price, which in this case is $8.30.
If we buy the $17 strike for $8.20 we are out $820, rather than the $2,349 we would spend for 100 shares of GDX. That’s a savings on capital required of 65.1%. Now we have the ability to use the capital saved ($1,529) to work in other ways.
The next step is to sell an out-of-the-money call against our LEAPS contract.
It seems as though the only call strike worth selling in GDX is the November 26 strike with 36 days left until expiration. If we chose a stock with a slightly higher price we could go out two, three, four or more strikes away from the current price of the stock. But, I want to use a very conservative example so we understand the basic risk/reward.
So, let’s say we decide to sell the 26 strike for $0.49, or $49, against our LEAPS contract.
Our total outlay or risk now stands at $771 ($820 LEAPS contract minus $49 call). At first, the premium seems small, but on a percentage basis selling the 26 call premium for $49 reaps a return on capital of 6.0% over 36 days. Of course, your upside is limited to $26 with this trade. But hey, is it so bad to lose out on some potential upside to make a 6.0% gain over 36 days?
An alternative way, if you wish to participate on a continued upside move in GDX, is to buy two leaps in the ETF and only sell one call against it. This will increase your deltas and allow half of your position to participate in a move past $26.
No matter the approach, we can continue to sell calls against our LEAPS contract every month or so to lower the total capital outlay. But remember, options have a limited life, so when we get closer to the LEAPS contract’s expiration we will simply sell the contract and use the proceeds to continue our poor man’s covered-call strategy.

More on the Poor Man’s Covered Call

I hope this helps give you all some additional food for thought regarding the power of options. Again, if you would like to learn more about the strategy, make sure you sign up for my latest webinar, where I discuss in great detail my approach to Poor Man’s Covered Call in my High Yield Trader service. Moreover, I plan to share four to five real-time trading examples to help shorten the learning curve. Click here to sign up.