Over the past several months I’ve discussed several of the options trading strategies I like to use in my overall portfolio given a variety of different market environments.
But today, I want to focus on how I build out portfolios using an options trading strategy that has performed incredibly well given all of the market turmoil this year.
The strategy is one that all investors, not just options traders, should consider especially if you are a fan of covered calls. The reason is because the strategy I’m about to discuss allows you to reap the benefits of a covered call strategy at a fraction (65% to 85% less) of the cost.
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Options Trading Strategy – Poor Man’s Covered Calls
The options trading strategy I want you to learn today is known as poor man’s covered calls. IT’s a powerful options trading strategy and one that I’m certain you will find advantageous in your future investment endeavors.
By using poor man’s covered calls I have the ability to diversify my strategies of choice for far less capital. This allows me to use a variety of different approaches that take advantage of different market environments.
For instance, in my Fundamentals options trading service I use poor man’s covered calls on an All-Weather portfolio, Dogs of the Dow portfolio, Growth/Value portfolio, Yale Endowment Portfolio, Buffett portfolio and potentially several others in the near future.
The one stalwart is the All-Weather portfolio, which is what I’m going to focus on today. The strategy has made positive strides this year which says a lot given how poorly the major indices have performed. In my mind, all investors should be using some form of an All-Weather portfolio as part of their overall investment strategy and coupling the proven long-term strategy with an options trading strategy like poor man’s covered calls allows investors far easier access to the strategy as the capital requirements, as mentioned before, are significantly lower.
The All-Weather portfolio is a portfolio that is available to the masses. All investors have access to some form of the risk-parity-based All-Weather Fund that was created by legendary hedge fund manager Ray Dalio.
All-Weather Portfolio
The portfolio is designed to survive all different types of market environments.
Here is a breakdown of asset allocation:
- 40% long-term Treasuries
- 20% U.S. stocks
- 10% International
- 15% intermediate-term Treasuries
- 5% commodities, diversified
- 5% gold
Next, I want to find a few ETFs that work. The selection is harder than you think because we have a few more requirements than just buying the ETF outright. We need to think about an ETF that:
- Falls into one of the asset classes above.
- Has liquid options.
- Offers LEAPS that have roughly two years until expiration.
Thankfully, there are choices, but I wouldn’t say they are plentiful. Liquid options markets can be tough in certain asset classes. As a result, I have no choice but to alter my allocation to differ ever so slightly from Dalio’s allocation.
Here is the allocation I use:
- iShares 20+ Year Treasury Bond ETF (TLT)
- Vanguard Total Stock Market Index (VTI)
- IShares 7-10 Year treasury Bond ETF (IEF)
- SPDR Gold Shares ETF (GLD)
- Invesco DB Commodity Index ETF (DBC)
The five ETFs above allow me the opportunity to buy LEAPS that have at least two years in duration. Again, the goal is to buy a LEAPS as far as possible and continue to sell short-term calls against my LEAPS contracts. Once my LEAPS have roughly 8 to 12 months of life left, I then begin the process of rolling my LEAPS contract out as far as I can and continue the process of selling more premium.
Historically, I have been able to outperform major market indices by three to five times using a poor man’s covered call approach while simultaneously limiting my downside risk.
Here is an example of how I would initiate a position.
iShares 20-Year Bond ETF (TLT)
TLT is currently trading for 105.45. Since adding TLT to the All-Weather portfolio the ETF is mostly flat. But by using our poor man’s covered calls approach we are up over 15% on the position.
My first step when using a poor man’s covered call options trading strategy is to choose my LEAPS call contract by the delta of the option. I prefer to initiate a LEAPS position by looking for a delta of 0.80. I discuss my initial set-up and how I manage my trades in great detail with my Fundamentals subscribers, but we just don’t have the time today. With a delta of 0.79, the January 19, 2024, 85 call strike with 484 days until expiration works.
I can buy one options contract, which is equivalent to 100 shares of TLT, for roughly $25, if not slightly cheaper. Remember, always use a limit order, never buy at the ask price, which in this case is $25.50.
If we buy the 85 strike call for roughly $25, we are out $2,500, rather than the $10,545 I would spend for 100 shares of TLT. That’s a savings on capital required of 75%. Now we can use the capital saved ($8,045) to work in other ways, preferably to diversify our poor man’s covered call strategy among other stocks and ETFs.
Once we make the initial LEAPS purchase, we can maintain that position and focus on selling near-term call premium against our LEAPS each month – thereby generating income and lowering the original cost basis with each transaction.
I begin the process of selling shorter-term calls against my LEAPS by looking for an expiration cycle with around 30-60 days left until expiration and then aim for selling a strike with a delta ranging from 0.20 to 0.40, or a probability of success between 60% to 85%.
The October 21, 110 strike call with a delta of 0.26 falls within my preferred range.
I can sell the 110 call for roughly $1.
My total outlay for the entire position now stands at $24. or $2,400 ($25 – $1) as opposed to $10,445 if I chose to buy 100 shares of the ETF. The premium collected is 4% over 29 days. Not a ton of premium, but remember, we are going out 29 days and using an ETF that has, by most comparisons a low level of implied volatility (IV).
But remember, again, if we were to use a traditional covered call options trading strategy our capital outlay would be $10,445 and our return would be 1%.
Also, the 4%, or 40% annually, is just the premium return, it does not include any increases in the LEAPS contract if the stock pushes higher. Since our initial delta is 0.53 (0.79 – 0.26), the LEAPS contract will increase by $0.53, roughly 2% for every dollar TLT moves higher.
The overall delta of the position will eventually hit a neutral state if TLT continues to move higher over the next 29 days. If it does, we simply buy back our short call and sell more premium.
So, as you can see above, we have the potential to create 4% every 36 days, or approximately 40% a year using a fairly conservative ETF like TLT. This is our baseline and should be our expected return in premium, but again this does not include any capital gains from our LEAPS position if TLT trends higher.
My next steps would be to add a position in VTI, IEF, GLD and TLT using the guidelines mentioned in my TLT example above.
As always, if you have any questions please feel free to post a comment or consider subscribing to a Cabot Options Institute advisory today.
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