Traders work on the floor of the New York Stock Exchange June 22, 2015. REUTERS/Brendan McDermid
One of the world’s most talented investors was a guy named Sir John Templeton.
Templeton was always a contrarian – launching an international investment business in 1947 – when NOBODY in the U.S. was investing overseas. He famously said:
“Bull markets are born on pessimism, grown on skepticism, mature on optimism and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.”
In my 20 years of active trading, I’ve discovered the benefits of being a contrarian.
So, when I see that a commodity like crude oil trading 65% below its all-time highs and near historic lows, I begin to search for the best way to take advantage of the opportunity.
One of my favorite income trading strategies is called 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, you simply buy an in-the-money LEAPS call and sells a near-term out-of-the-money call against it.
LEAPS – also known as 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 you 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.
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 United States Oil Fund (USO).
The ETF exemplifies the typical scenario 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 USO.
If you were to buy USO shares at $10.21 per share, your capital requirement would be a minimum of $1,021 plus commissions ($10.21 times 100 shares).
If we look at USO’s option chain, we will quickly notice that the expiration cycle with the longest duration is the January 2020 cycle, which has roughly 837 days left until expiration.
With the stock trading at $10.21, I prefer to buy a contract that is in the money at least 10%, if not more. Let’s use the $8 strike for our example.
Oil and Long Term
Yes, I’m talking about oil. It’s currently trading at around $49 a barrel. That’s down from all-time highs around $142.
Contrarians often look like dummies in the beginning. But with oil, it’s about the long term. As an investor, what I don’t want to risk is potentially losing out on an opportunity to invest in a crucial resource at an 65% discount just to avoid the possibility of looking foolish. As an investor, I couldn’t care less about the opinions of others. I simply focus on my own research and attempt to take calculated risks that will put me in the best position to succeed.
You can buy one options contract, which is equivalent to 100 shares of USO, for roughly $3.10, if not cheaper. Remember, always use a limit order – never buy at the ask price, which in this case is $3.25.
If you buy the $8 strike for $3.10 we are out $310, rather than the $1,021 you would spend for 100 shares of USO. That’s a savings on capital required of 69.6%. Now you have the ability to use the capital saved ($711) to invest 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 USO is the December 10.5 strike with 74 days left until expiration. If you chose a stock with a slightly higher price you could go out two, three, four or more strikes away from the current price of the stock. For this example, I want to use a very conservative example so you understand the basic risk/reward.
So, let’s say we decide to sell the 10.5 strike for $0.38, or $38, against our LEAPS contract.
The total outlay or risk now stands at $272 ($310 LEAPS contract minus $38 call). At first, the premium seems small, but on a percentage basis selling the 10.5 call premium for $38 delivers a return on capital of 12.2% over 74 days. Of course, your upside is limited to $10.50 with this trade.
But hey, is it so bad to lose out on some potential upside to make a 12.2% gain over 74 days