Using Deep ITM Calls as a Stock Replacement (Poor Man’s Covered Call)

The “Poor Man’s Covered Call” (PMCC) is a popular options technique that substitutes outright stock ownership with a deep in-the-money (ITM), long-dated call as the long leg and a short, nearer-dated call as the income leg. The idea: get most of the stock’s upside with a fraction of the capital and sell premium to offset cost. This article explains how the trade works, why investors use it as a stock replacement, the math, advantages, and the risks retail traders must know.

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What the Strategy Looks Like (Structure)

A basic PMCC has two parts:

• Long deep ITM call (long-dated): Buy a call option with a strike well below the current stock price and with long time to expiry (months to years). This acts as your synthetic stock.
• Short near-dated OTM call (monthly/weekly): Sell a call with a higher strike and short expiry to collect premium and reduce net cost.

Net position = long deep ITM call − short near-dated call. Over time you roll the short call (close it near expiry and sell the next one).

Why Deep ITM Calls Can Replace Stock

• High delta (≈0.7–0.95): Deep ITM calls move almost like the stock. If a call has delta 0.90, a ₹1 rise in stock increases the option price by ~₹0.90.
• Capital efficiency: You pay only the option premium instead of full share price. Example below shows the arithmetic.
• Limited explicit cash at risk: The maximum you can lose on the long call is the premium paid (unlike stock, which can fall to zero).
• Income from short calls: Selling short calls generates recurring premium that lowers net cost (like receiving dividends or rental income).

A Simple, Clear Example (Digit-by-Digit Math)

Assumptions (hypothetical):

• Stock price = ₹1,000.
• Deep ITM long call: strike ₹800, time to expiry 18 months. Intrinsic value = 1,000 − 800 = ₹200. Time premium = ₹50 → total premium = ₹250.
• Short near-dated call: strike ₹1,100, one-month expiry, premium received = ₹10.

Compare Capital Outlay and Exposure

• Buy 1 share: cost = ₹1,000 cash outflow.
• PMCC long call: cost = ₹250 premium (cash outflow). Sell short call gives ₹10 inflow, so net upfront cash = ₹250 − ₹10 = ₹240.

If Stock Rises to ₹1,100 by Next Month:

Share owner gains ₹100 (from 1,000 → 1,100).

Call holder (delta≈0.9) — approximate option gain: 0.9 × ₹100 = ₹90 (ignoring small extrinsic changes). Short call sold at 1,100 is likely exercised; premium income ₹10 offsets. Net approx gain ≈ ₹90 + ₹10 = ₹100 — close to stock owner’s outcome, while capital locked was only ₹240 vs ₹1,000.

If Stock Falls to ₹800:

Share owner loses ₹200.

Long call may be near-worthless: loss limited to premium ₹250 (but remember short call premium reduces that to ₹240 net cost). So downside is capped to your net premium rather than full share loss.

This shows how PMCC mimics stock exposure but with far lower initial capital and limited explicit downside (premium).

Advantages (Why Investors Use It)

• Lower capital required — frees up cash for other uses.
• Defined downside (premium paid) — useful for capital-constrained investors.
• Income generation — rolling short calls can offset cost and sometimes produce net credit.
• Flexibility — you can adjust strikes, expiries and roll patterns to tune risk/reward.

Pitfalls & Practical Risks (What Can Go Wrong)

• Time decay (theta): Long calls have negative theta; long-dated deep ITM calls have smaller relative theta, but the short near-dated calls can decay faster — net theta depends on structure.
• Less than 1:1 upside participation: Delta < 1 means you slightly underparticipate in upside compared with owning the stock outright.
• Assignment & physical settlement (market-specific): If you sell calls on stock options that are physically settled, you may face delivery obligations near expiry. Check contract specs and broker rules in India/your market.
• Liquidity & spreads: Long-dated deep ITM options and some short strikes may have wide bid-ask spreads, increasing transaction cost.
• Margin/lot sizing: In markets with fixed lot sizes, you must match contracts to intended exposure, which can make fine sizing difficult.
• Opportunity cost: Owning the call instead of the stock may mean missing corporate actions (dividends, bonus) depending on product and market—check how underlying corporate events affect option pricing and your entitlements.
• Taxation: Option gains/losses and premium income may be taxed differently than equities. Rules vary; consult a tax advisor.

Implementation Checklist (Practical Steps)

• Pick liquid underlying (narrow option spreads, active OI).
• Choose long call: deep ITM, long-dated (delta 0.7–0.95) to mimic stock.
• Sell short calls monthly/weekly to collect premium; choose strike based on acceptable upside cap.
• Size to delta: to approximate one share, buy ~1/delta long calls (e.g., delta 0.8 → buy 1.25 contracts equivalent). In practice, use nearest whole contracts and adjust with additional options or part equity.
• Monitor IV and roll strategy: sell when IV is attractive, avoid selling into spikes if you’re not comfortable with potential assignment.
• Account for transaction costs & tax before committing.
• Have exit rules: if IV collapses or stock gaps, know when to close legs or convert to actual stock.

Conclusion

The Poor Man’s Covered Call — using a deep ITM long call as a stock replacement combined with short calls for income — is a useful capital-efficient strategy for investors who want equity-like returns with lower upfront cash and defined downside risk. It’s not risk-free: you trade full upside participation for lower cost, face time-decay and volatility risks, and must handle assignment and settlement mechanics. For retail traders on 5paisa, this strategy can be attractive when implemented on liquid stocks with careful sizing, disciplined rolling, and a clear plan for taxes and settlement. Always paper-trade the structure and consult your broker or tax adviser before you deploy real capital.