?> March 2022 - projectfinance

Month: March 2022

FAQ: Can You Cash Out a Life Insurance Policy for Retirement?

Posted on by Mike Martin

Last updated on April 6th, 2022 , 07:07 pm

Life Insurance Policy for Retirement

Insurance is a fact of life in our money-driven world. Car insurance is necessary to protect your vehicle and yourself from the repercussions of a collision. Medical insurance is required to obtain reasonably-priced medical care, at least in the United States. Dental insurance, Vision insurance, Renters, or Homeowners insurance; are all crucial kinds of protection.

In general, the concept of insurance is simple. You pay a monthly premium to maintain coverage. If something happens to whatever you’re covering (your vehicle, your health, your teeth, your home), the insurance kicks in to pay for whatever damage or replacement is necessary.

What about life insurance?

The tricky part about life insurance is that it’s strangely positioned in our culture. 

  • It’s often viewed as something you don’t need to worry about until you’re old, when it may start paying out.
  • It’s not legally mandated how health or car insurance coverage often is.
  • It’s complex enough that many people don’t want to learn about it.

Life insurance sounds simple. You pay into a policy that, when you pass away, pays out to your family. This payout can help keep them financially stable as they seek to replace your income or cover funeral and other associated expenses. Of course, all too often, people don’t think about the repercussions of their passing. 

There are many potential benefits to life insurance while you’re still alive, including the potential to cash in your policy for immediate financial help. The question is, how?

What Are The Benefits of Life Insurance?

There are quite a few benefits to life insurance, both for you and your family.

Benefits of Life Insurance

1. It’s tax-free when it pays out.

First and foremost are the tax implications. Inheritance and other forms of death-based windfalls are classified as income in some form or another and are typically taxed. Life insurance policy payments are not classified as taxable income, so your family won’t have to suffer an unexpected tax burden.

2. The money isn’t restricted.

When your loved ones receive a payout upon passing, that money is treated as ordinary money. They aren’t required to use it in one specific way; instead, they can use it for anything. This includes ongoing living expenses to a child’s college education, funeral expenses, and more.

This can be an extremely beneficial windfall for many. Considering that recent estimates place 64% of the population living paycheck to paycheck, having the insulation of a payout for many unforeseen costs relating to end of life can be highly beneficial.

Consider that the general recommendation for coverage is 7-10 times your annual income. This can mean 5-10 years of living expenses covered for your family, assuming a consistent standard of living and expenses. 

3. You may be able to cash out your insurance policy early.

Living expenses and medical bills can pile up as you reach retirement age or older, while income generally doesn’t. The usual goal is to accumulate enough wealth in retirement savings throughout your life to live comfortably in retirement, but that’s not always possible. 

You can use some forms of life insurance policy in various ways to support you in retirement, in your later years, or with specific end-of-life bills. How? Let’s discuss it in greater detail.

What Are The Different Types of Life Insurance?

If you’re hoping to get a payout for your life insurance policy while you’re still alive, you’ll need to understand the different types of life insurance and the kind of policy you have. Some types of life insurance have payouts, while others do not.

Types of Life Insurance

Here’s a brief rundown.

  • Term Life Insurance. You buy a fixed-duration policy of anywhere from one year to 30 years annually. If you pass away during that time, your family receives a payout. If you don’t, the policy expires, and no one except the insurance company gets anything. These policies have higher payouts and lower premiums to balance this risk.
  • Whole Life Insurance. You buy a policy that lasts until you die, whether that be five years from now or 40. You enroll, pay an annual premium, and are covered forever. You get a guaranteed return on your investment, and the policy accrues cash value as you pay into it.
  • Variable Life Insurance. These are variations of life insurance tied to investment accounts – the cash value of the investment rises (or falls) according to the investment vehicle attached to the policy. However, the death payout remains static, as do the premiums.

There are other variations, but these are the main versions.

A key takeaway here is that “term life insurance” cannot be cashed out. To cash out your policy or receive money from it, it needs to have some cash value. 

Term life insurance generally does not have a cash value attached, while whole life and variable insurance policies do. Term life insurance may be convertible into a permanent form of life insurance and thus enable being cashed out. Still, these policies require specific riders, usually when you’re signing up for them.

How Can You Get a Payout from Life Insurance?

Generally, there are three different ways you can get a payout from life insurance while you’re still alive. Each of these ways may have sub-options, so let’s discuss them.

1. Life Settlements

First up is the life settlement. A life settlement is selling your life insurance for a one-time payment. This payment is higher than the surrender value (which I’ll discuss later) but lower than the death benefit the policy would pay when you pass.

Life Settlements

In other words, you’re transferring your policy from yourself to a third party, usually a company that specializes in precisely this transaction.

  • The purchasing party becomes responsible for the premiums on the policy and receives the payout when you pass.
  • You receive an immediate cash payout, tax-free, which you can use for your retirement and expenses.

The biggest downside to this option is leaving your family without those benefits when you pass. If you settle your policy and then use up all of the money on retirement living expenses, your family is left with nothing but your inheritance when you pass. Of course, if you have no living family, this is a moot point.

Unfortunately, one of the biggest reasons people cash out their policy is because the lower income they have during retirement means they can no longer afford the premiums. Other unexpected expenses can require more money on hand and the desire to sacrifice uncertain future benefits for immediate tangible benefits. Selling the policy early and taking a hit is better than not being able to pay and losing your coverage entirely.

2. Cash Value

As mentioned above, whole life insurance and several other kinds of life insurance, such as variable life insurance, have a cash value attached to them. Your premiums are higher, but part of your payments goes into an account that accrues value. 

In variable, indexed, and other forms of life insurance, this may be more explicit, with the cash value riding in a market account and investing in the market through normal means, similar to retirement accounts.

Cash Value

There are three ways for a policyholder to access the cash value of their life insurance.

1.) Surrender is the first. This means, essentially, canceling your life insurance in exchange for a payout of the insurance’s cash value. You gain the cash value when you surrender your life insurance, minus a few minor processing fees. This money is then yours to do with as you will. 

Surrender may have tax implications since it is weighed against the amount you have paid as premiums. Some policies also have repercussions and penalties if you cash out while still under a specific age limit, which varies per policy.

Of course, the biggest downside of surrender is the subsequent lack of life insurance. When you pass away, your policy is already gone, so your family does not receive a death benefit.

2.) The second option is a loan. Many policies allow you to take out a loan consisting of some of the policy’s cash value. You are encouraged to repay it as a loan, though there’s generally no set repayment schedule.

These loans accrue interest if you don’t repay them. Moreover, when you pass, the value of the loan plus its interest are deducted from the death benefit paid out by the policy. The death benefit may be reduced significantly depending on how long ago you took out the loan, how much value the loan had, and how much interest accrues.

3.) The final of the three options is withdrawal. Withdrawing is similar to a loan in that it can reduce the final death payout since the payout is generally the policy value plus the cash value. Pulling cash out earlier than expected will reduce that portion of the payout.

The cash value of a life insurance policy can also be used as “implicit income” by reducing expenses. Specifically, some policies allow you to use the cash value to pay the policy’s premiums, making them more or less self-sufficient until the cash value is gone. This process leaves you with more freedom to use the rest of your money in other ways.

3. Living Benefits

The third way to get value from your life insurance policy before passing away is using the living benefits riders on your policy (if it has them). There are three main ways these benefits can occur, but these may be riders you need to attach to your policy rather than options freely available to everyone. Be sure to talk to your insurance agent to see if you have these riders. 

These riders are often called Accelerated Benefit Riders. They are usually optional and may not be available on all policies. Their payouts can range from 25% to 100% of the death benefit you would receive, either as a lump sum or as monthly payments. Typically, they increase the cost of the life insurance policy along the way.

Living Benefits

The three riders are:

  • Chronic Illness. If you suffer from an ongoing chronic illness and need significant help with daily tasks and ongoing expenses, you can get a chronic illness payout from your insurance. Chronic diseases include AIDS, heart disease, diabetes, asthma, high blood pressure, and more. 
  • Long-Term Care. LTC benefits are paid out when you require ongoing, long-term care such as assisted living or hospice care, nursing home care, or other forms of continuing care. The rider helps pay for that care as long as you need it.
  • Terminal/Critical Illness. Sometimes, a doctor will diagnose an illness you have and estimate that you have less than 12 months to live based on similar cases and your overall health. In these cases, you can receive a terminal illness payout to help with end-of-life care and other expenses associated with that final year of life.

In general, you have to work with a doctor and meet specific requirements to access these early payment riders. If you don’t meet the criteria, you can’t get the money and will need to resort to one of the other options.

Should You Cash Out?

Whether or not to cash out your life insurance largely depends on personal circumstances, so there’s no one correct answer.

Should You Cash Out

Typically, if you no longer have dependents or a family that would benefit from a death payout, receiving money early to live your own life is better than letting that money evaporate or go to the state. 

Early payments may also be beneficial to maintain the quality of life and enjoy your retirement if you otherwise don’t have the money to do so. 

In the end, the choice is yours.

Now, we turn to our readers. Are you weighing the pros and cons of cashing out your life insurance policy for retirement? What is your current situation? If you have any questions for us, please share them in the comments section below! We’d love to hear from you, and we make it a point to respond to our readers.

Next Article

Target-Date Funds vs S&P 500 Index Funds: Which is Better?

Posted on by Mike Martin

Last updated on April 19th, 2022 , 01:38 pm

Target Date Funds vs S&P Index Fund

Choosing between target-date funds and index funds is a very common dilemma for retirement investors with a long-term time horizon.

➥ Target-date funds are incredibly diverse investment products that aim to grow assets for a specific time frame. These low-cost funds are actively managed and restructured to offset risk as the target retirement date approaches using the “glide path” approach.

➥ S&P 500 Index funds are generally less diverse investment vehicles that have no time frame.

Because index funds have no “targeted” date, the holdings within these funds do not adapt to investors’ risk tolerance, which generally decreases with age. 

For long-term, retirement-minded investors, target-date funds appear to be the better investment strategy. Why? Target funds simplify the process of saving for retirement. Instead of choosing amongst dozens of equity and bond funds, target-date funds only require you to have one position! Within this one position are numerous assets and types of securities. 

But which type of fund actually performs best? 

Though nobody knows what will happen in the future, this article aims to compare the past performance of target-date funds with index funds, specifically index funds that track the S&P 500 benchmark. 

              TAKEAWAYS

  • Target-date retirement funds are designed to reduce risk as time passes and the target retirement date approaches.

  • S&P 500 index funds represent the largest 500 companies in the US and are not custom-tailored to investors changing risk levels.

  • Target-date funds contain equities of all market caps, as well as bond, international, and emerging market stocks.

  • American stocks tend to outperform both bonds and international stocks over time.

  • S&P 500 index funds can be combined with target-date funds for investors looking for more American equity exposure.

  • Index funds typically have marginally smaller fees than target-date funds, though these higher expense ratios are negligible. 

How Do Target Date Funds Work?

Target-Date Fund Definition: A target-date fund – also known as an age-based or lifecycle fund – is a mixed allocation fund that seeks to grow assets over a specified time period for a target date.

When you’re 25, you can and should take on more risk than when you’re 55. 

But how do you know what proportion of your retirement and savings should be in fixed-income (bonds) versus equities at various stages of your life? What about the large-cap to small-cap ratio? And what about money markets?

Target-date funds were designed to do this work for us. These funds rebalance as the target date approaches to change with investors risk appetites, which decrease with age.

Before the target-date fund, if an investor didn’t have a financial advisor, determining asset allocation was pretty much guesswork. And there really is no right answer – just a lot of grey.

To learn more about the various asset allocation strategies, check out our article, “What’s the Best Stock to Bond Ratio for Your Age?“

To remedy this huge problem, the target-date fund was created.

Target-Date Funds History

In 1994, Barclays teamed up with Wells Fargo to create a fund that “safely” brought investors to a future date, typically a retirement date.

The result was the first target-date retirement fund. Since that time, the below firms have offered target-date funds:

The most popular provider of these target-date funds, as reported by CNBC in 2022, is Vanguard. This article is going to focus completely on funds from Vanguard, though the target-date funds from all of the above families have similar asset allocation strategies. 

Since this article is going to be comparing target-date funds with index funds, let’s explore the world of index funds before we move on

How Do Index Funds Work?

Index Funds Over Time

Index Fund Definition: Index funds can be either mutual funds or exchange-traded funds (ETFs). Index funds seek to track the returns of a market index. 

So index funds track market indices. What type of market indices do they track? Innumerable. Let’s look at a few of the more popular ones now:

In order to invest in these indices, investors can either purchase mutual funds or ETFs. ETFs are becoming more popular investment vehicles because of their low fees and high liquidity. 

This article is going to focus primarily on S&P 500 index funds, specifically those offered by Vanguard. There are two main products Vanguard has that provide cheap access to the S&P 500:  Vanguard’s 500 Index Fund Admiral Shares mutual fund (VFIAX) and Vanguard’s Vanguard S&P 500 ETF (VOO).

These two products are identical in almost every way. Two exceptions lie in their structure and fees:

1.) VFIAX charges a fee of 0.04%; VOO charges a fee of 0.03%

2.) VFIAX is not exchange-traded; VOO is exchange-traded

ETFs (like VOO) are exchange-traded, meaning you can buy and sell them during market hours. Mutual funds (like VFIAX) can only be traded once a day, and you never know the fill price you are going to get when you place a buy or sell order on a mutual fund. 

Advantage ETF!

For these reasons, this article will be using the VOO as its benchmark when comparing the performance of target-date funds. VOO is a top-rated S&P 500 tracker, earning 5 stars at Morningstar.  

ETF vs ETN vs ETC vs ETP: Learn the difference here!

Target Date Funds vs Index Funds: Similarities

Target-date funds have a lot in common with index funds. After all, target-date funds are comprised of index funds! In theory, you should be able to mirror any target-date fund on your own with index funds. 

This is a good strategy for investors with both higher and lower risk tolerances than the benchmark target-date fund. For investors wanting less risk, more bond funds, as well as money market funds, can be used in tandem with the target-date fund. For more risk-on investors, equity index funds can be used to supplement target-date funds.

All investors have different risk appetites. Investing is not a one-size-fits-all business. So why are target-date funds so popular? Because they’re easy and cheap!

Let’s next look under the hood of both target-date funds and index funds. 

Target-Date Funds vs Index Funds: Comparing Fees

Investing can be a costly endeavor. Funds fees can predict the future success or failure of a fund.

Fund issuers must employ teams of fund managers and price stabilizers to make sure the funds do indeed track the underlying index.  

The management fees for both Vanguard’s index funds and Vanguard’s target-date funds are both very low. However, target-date funds do have marginally higher fees.

Just about all Vanguard funds are comprised of four underlying index funds. Let’s take a look at these four fund fees individually, then take a look at the expense ratios of various target-date funds.

 

Index Fund Fees

Fund Expense Ratio

Vanguard Total Stock Market Index Fund Institutional Plus Shares (VSMPX)

0.02%

Vanguard Total International Stock Index Fund Investor Shares (VGTSX)

0.17%

Vanguard Total Bond Market II Index Fund Investor Shares (VTBIX)

0.09%

Vanguard Total International Bond Index Fund Investor Shares (VTIBX)

0.13%

The above funds are what constitute the vast majority of Vanguard’s target-date funds. So what fees do the actual target-date funds charge? Let’s find out!

Target-Date Fund Fees

Fund Expense Ratio

Vanguard Target Retirement 2030 Fund

0.08%

Vanguard Target Retirement 2040 Fund

0.08%

Vanguard Target Retirement 2050 Fund

0.08%

Vanguard Target Retirement 2060 Fund

0.08%

Given the relatively high fees for Vanguard’s “International Stock” and “International Bond” funds, the expense ratios for target-date funds are pretty much as they should be. 

But what are the fees for VOO, Vanguard’s S&P 500 index-tracking ETF?

Vanguard S&P 500 ETF (VOO) Fee: 0.03%

Therefore, we can conclude that investing solely in Vanguard’s S&P 500 ETF is cheaper than investing in target-date funds. 

 

Target Date Funds vs Index Funds: Asset Categories

target date funds vs index fund

S&P 500 index-tracking ETFs and mutual funds provide exposure to the 500 largest companies listed on stock exchanges in the United States. All of these companies fall under the “large cap” umbrella.

Target-date retirement funds also invest in large-caps, while adding:

  • Small-cap equities
  • Mid-cap equities
  • International equities
  • Bonds

Let’s next break down a few of these asset classes target-date funds invest in.

Target-Date Funds: Bond Exposure

We are taught from a young age that diversification is the best way to go in investing. That includes investing in both bonds AND stocks. But we are not living in our parents’ age, nor our grandparent’s age. 

In 2022, interest rates are rising, but many financial professionals believe rates will never again rise to the heights of previous decades. 

In fact, interest rates have been declining steadily since the Black Death of the 14th century! Many asset managers believe low-interest rates are here to stay. 

So why does this matter to us? Target-date funds are quite bond heavy. Bonds are generally less attractive than stocks in low-interest-rate environments. 

Over the course of a few decades, having 15% of your portfolio producing relatively poor returns may be ballast on your retirement plans. 

Additionally, bonds have taken a considerable hit this year. In the first four months of 2022, Vanguard’s Total Bond Market Index Fund ETF Shares (BND) has fallen over 4%. Quite volatile indeed for a historically “safe” asset class!

Though bonds have indeed been underperforming, it is important to note that bonds provide investors a great source of retirement income. 

BND 6 Month Performance

BND 6 month performance

Target-Date Funds: International Exposure

➥ S&P 500 ETFs and mutual funds invest only in American companies. 

➥Target-Date Funds invest in stocks from all over the world. 

Let’s get right into comparing the historical performance of American stocks with international stocks:

International vs Domestic Stocks: 11 Years

American vs international stocks

Over the past 11 years, the S&P 500 (as represented by VOO in gold) has returned 314%. During this same time, international stocks have returned 22.68% (as represented by Vanguard’s Total International Stock ETF (VXUS).

Does this mean international stocks are poised for a comeback? Perhaps. But for the past 11 years, international stocks have barely kept up with inflation. For me, that’s a red flag for what’s to come.

Now that we have an idea of the different types of assets and securities that comprise target-date funds, let now compare them with S&P 500 index funds.

Vanguard's 2030 Target-Date Fund vs S&P 500

The below image shows the holdings for Vanguard’s Target Retirement 2030 Fund (VTHRX).

VTHRX Holdings

VTHRX Holdings

Let’s focus on that first fund, Vanguard’s Total Stock Market Index Fund (VSMPX).

All Vanguard target-date funds have this monster within them. This is where we are going to see overlap with S&P 500 index funds.  

In addition to containing all S&P 500 stocks, VSMPX adds small-, mid-, and large-cap growth and value stocks.

Since this fund has a target-date only 8 years away, VTHRX (2030 target-date) is very conservative, having 35% of its holdings in bonds. 

So how does this fund stack up against the S&P 500?

VTHRX vs VOO: 10 Year Total Total Return

VTHRX vs VOO

As we can see, the S&P 500 has vastly outperformed Vanguard’s 2030 target-date retirement fund during the past 10 years.

Of course, this is to be expected given the planned retirement date for this investor is only 8 years away. As target-date retirement funds approach their specified date, the funds become more conservative and (in bullish markets) generally underperform the S&P 500.

Vanguard's 2040 Target-Date Fund vs S&P 500

Let’s skip ahead ten years and now and check out Vanguard’s Target Retirement 2040 Fund.

 

VFORX Holdings

VFORX holdings

As we can see, Vanguard’s 2040 fund is a little less conservative than its 2030 fund, having about 20% of its assets invested in bond funds. 

Additionally, this fund has an international equity exposure of 32%, compared to the 2030s international equity exposure of 26%.

So how has this slightly more aggressive fund performed over the last ten years in relation to the S&P 500 (as represented by Vanguard’s VOO S&P 500 ETF)?

VFORX vs VOO: 10 Year Total Return

VFORX vs VOO

Because of this fund’s slightly higher equity exposure, it has performed slightly better than the 2030 retirement fund over the past decade. However, the fund still pales in comparison to the S&P 500.

Vanguard's 2050 Target-Date Fund vs S&P 500

The next fund on our list is Vanguard’s Target Retirement 2050 Fund (VFIFX). Let’s see what’s under the hood!

VFIFX Holdings

VFIFX Holdings

Relative to Vanguard’s 2040 fund, Vanguard’s 2050 target-date fund reduces its bond exposure to 10% while increasing its international equity exposure to 36%. Additionally, its US equity exposure has increased by 6%.

So how has this more aggressive fund stacked up to the S&P 500 over the past decade?

VFIFX vs VOO: 10 Year Total Total Return

VFIFX vs VOO

As expected, due to its more aggressive nature, VFIFX outperforms the 2030 and 2040 funds. However, when comparing VFIFX to the S&P 500, we can see it has vastly underperformed.

Vanguard's 2060 Target-Date Fund vs S&P 500

The last target-date fund we will be looking at is Vanguard’s Target Retirement 2060 Fund (VTTSX).

VTTSX Holdings

VTTSX Holdings

This fund currently has over 90% of its holdings in equities and less than 10% in bonds.

So how has this fund performed in relation to the S&P 500?

VTTSX vs VOO: 10 Year Total Return

VTTSX vs VOO

The further away a target date becomes, the more Vanguard target-date funds begin to mirror one other. 

Vanguard’s 2060 fund is almost an exact replica of its 2050 fund. 

They both have ≈ 54% of their holdings in US stocks, ≈36% in international stocks, and ≈10% in bond funds. 

The ten-year performance of the 2050 and 2060 fund is therefore almost identical. 

However, when compared to the S&P 500 – again – they both underperform quite dramatically.

Target-Date Funds vs S&P 500: Which Is Right for You?

Target-date funds get a lot of things right (they produce a phenomenal diversified portfolio for individual retirement accounts) – but they get a lot of things wrong as well:

  1. Target-date funds do not take into consideration investments held outside the fund.

  2. Target-date funds assume all investors have the same risk tolerance.

  3. Target-date funds do not adapt to the ever-changing financial needs of investors.

  4. Many financial professionals believe retirement savers should have more equity exposure than target-date funds offer.

Let’s focus for a moment on the fourth item on the list. 

Warren Buffet has recommended that retirement savers should have 90% of their savings in equity at all times with the remaining 10% invested in bonds. 

Perhaps this approach is too aggressive, but investors do not need to choose one or the other. 

A great investment portfolio strategy (particularly for traditional and Roth IRAs) is to keep a portion of your retirement savings in target-date funds while managing the remaining funds on your own. This will allow you to reach the bond/equity ratio that best suits your individual risk tolerance. This approach will also allow you to invest in more asset classes, such as real estate funds. 

Additionally, having the bulk of your funds in a target-date fund will help shield you from market volatility. 

 

Target-Date Fund vs Index Funds FAQs

In bull markets, index funds that track the S&P 500 tend to outperform target-date funds. However, during times of high volatility, equity index funds will generally lose more in value than target-date funds, which are more conservative.

Many investment professionals believe that target-date funds do not provide enough equity exposure. Investors must understand their own risk tolerance before determining if target-date funds are too conservative (or too aggressive).

Target-date funds are very diverse products that change and grow with investors risk appetites’ (which decreases with age); index funds are static and do not adjust over time to meet investors changing needs. 

Next Lesson

What is UVIX? (2x Long Volatility ETF Explained)

Posted on by Chris Butler

Last updated on March 29th, 2022 , 09:51 am

Volatility has become a tradable asset class due to the success of volatility ETPs such as VXX, SVXY, and UVXY.

UVIX is one of the newest products entering the volatility trading space, restoring the 2x leveraged long volatility exposure that UVXY once had.

What is UVIX and How Does it Work?

The Long VIX Futures ETF (Ticker: UVIX) seeks to provide daily investment results, before fees and expenses, that correspond to 2x the Long VIX Futures Index (Ticker: LONGVOL).

UVIX is the 2x Long VIX Futures ETF, returning 2x the daily percentage change of a portfolio composed of first and second-month VIX futures.

The inception date of UVIX is scheduled to be March 30th, 2022. Volatility Shares is the issuer of UVIX.

Let’s explore the Long VIX Futures Index mentioned in the product description to learn how UVIX works.

What is the Long VIX Futures Index (LONGVOL)?

The benchmark UVIX tracks is the Long VIX Futures Index (LONGVOL) by Cboe.

Index Methodology: LONGVOL tracks the daily performance of a theoretical portfolio of first and second-month VIX futures contracts that are rolled daily. The portfolio aims to hold a mixture of the two futures to achieve a weighted average of 30 days to settlement.

If it is February 1st, the first-month VIX future will be the February contract, and the second-month VIX future will be the March contract.

The Cboe LONGVOL Index tracks the daily percentage changes of a portfolio composed of first and second-month VIX futures.

VIX futures track the Cboe Volatility Index (the VIX Index), which increases during times of heightened market volatility and falls during calm market periods.

A long VIX futures position profits when the:

  • VIX index increases to higher levels, pulling VIX futures contracts up along with it.

  • VIX futures curve is in backwardation, causing short-term futures to drift higher as they converge towards the higher VIX index.

The LONGVOL index will therefore increase during rising or persistently high volatility market conditions where VIX futures are in backwardation.

Bullish UVIX traders are effectively long Cboe volatility index futures.

Bearish UVIX traders are effectively short Cboe volatility index futures.

LONGVOL Movement Examples

The past performance of the LONGVOL index informs us about how UVIX should perform under various market conditions:

LONGVOL past performance. Long-term trend is to zero, with some spikes during high volatility markets.

During extended periods of low volatility, UVIX will lose substantial value driven by consistent contango in the VIX futures market, leading to decaying near-term VIX Futures.

VIX Contango: The Ultimate Beginner’s Guide

Consequently, the share price of UVIX will decay immensely, as LONGVOL did during the persistently low volatility of 2016. Here is LONGVOL during the first few months of 2016:

LONGVOL index in 2016.

From February 2016 to June 2016, LONGVOL fell from 7,600 to around 3,600, a decrease of over 50%. UVIX would have experienced an even worse decline, as it tracks 2x the daily percentage change of LONGVOL.

But during periods of surging market volatility, UVIX will gain significant value. The faster the increase in volatility, the larger the increase UVIX will experience.

Here’s what LONGVOL did in early 2020:

LONGVOL index in 2020.

Source: Cboe

If you’re familiar with UVXY, it used to have 2x long volatility exposure like UVIX. After the “volmageddon” of 2018, UVXY’s leverage was reduced from 2x to 1.5x.

UVIX is the new 2x long volatility product, restoring the previously accessible 2x leverage to the long volatility product space.

While UVIX may experience exponential returns during periods of rapidly increasing or persistently high volatility, the long-term trend in UVIX will be down as VIX futures are in contango a majority of the time during normal market conditions.

What is the Difference Between VIX and UVIX?

The VIX cannot be traded directly. UVIX allows positive leveraged exposure to changes in the VIX index through the VIX futures market.

The Cboe VIX Index is a calculation of market implied volatility using S&P 500 Index options with around 30 days to expiration.

The VIX index cannot be traded as there are no underlying shares. It is only a calculation.

To trade anticipated changes in the VIX index, traders turn to VIX futures and options.

Trading VIX futures is a risky endeavor, as one VIX futures contract represents $1,000 per point in notional value (a large position). A 10-point move in a VIX futures position translates to a P/L of $10,000 on one contract.

UVIX is an ETF that tracks the LONGVOL index, which tracks 2x the single-day percentage changes of the first and second-month VIX futures contracts.

For instance, if it is February 1st, LONGVOL will track 2x the single-day percentage changes of a mixed portfolio of February and March VIX futures contracts.

UVIX is a volatility product that allows traders to gain leveraged exposure to changes in the VIX index through the futures market.

VIX Index <= VIX Futures <= UVIX

What is the Difference Between UVIX and SVIX?

UVIX, the 2x Long VIX Futures ETF, seeks to provide daily investment returns, before fees and expenses, that correspond to twice the performance of the Long VIX Futures Index (LONGVOL).

UVIX is a 2x leveraged long volatility product.

UVIX aims to return 2x the daily percentage change of a portfolio consisting of first and second-month VIX futures contracts.

SVIX, the Short VIX Futures ETF, seeks to provide daily investment returns, before fees and expenses, that correspond to the performance of the Short VIX Futures Index (SHORTVOL).

SVIX is a short volatility product.

SVIX aims to return -1x the daily percentage change of a portfolio consisting of first and second-month VIX futures contracts.

Read our full guide on SVIX.

UVIX is a 2x (leveraged long) volatility ETF. SVIX is a -1x (short) volatility ETF.

How Risky is UVIX?

UVIX is a high-risk leveraged volatility product.

UVIX should not be held as a long-term “investment.” Buying shares of UVIX does not represent ownership of any business, unlike buying shares of SPY.

During calm market periods where the VIX futures are in contango, UVIX will lose value steadily from the decaying VIX futures.

The investment strategy of holding UVIX during low market volatility with the anticipation of increasing market volatility is not easy.

In the event of a short-term volatility spike, UVIX can gain significant value, but over time, it should trend towards zero.

UVIX is designed for short-term stock and options trading, not long-term “investing.” It is incredibly expensive to hold long volatility positions constantly, as VIX futures lose value when in prolonged periods of contango.

Additionally, the complex nature of UVIX can cause uninformed traders to lose money due to a lack of understanding of the product’s mechanics.

I do not recommend making any trades in UVIX unless confident in your understanding of how it works, and the risks of your specific trades.

How is UVIX Calculated?

UVIX is benchmarked to the Long VIX Futures Index (LONGVOL).

LONGVOL tracks the daily performance of a theoretical portfolio of first and second-month VIX futures contracts that are rolled daily.

Each day, the net asset value (NAV) of UVIX should correspond to:

Previous Closing Price + 2x the Current Trading Day’s LONGVOL Change (%)

Example: UVIX closes at $50 on Monday.

On Tuesday, if the LONGVOL index increases by 3%, UVIX shares should trade 6% higher at $53 ($50 x 1.06).

Conversely, if the LONGVOL index falls by 10%, UVIX shares should fall 20% to $40 ($50 x 0.80).

The above examples represent no tracking error (perfect tracking of index performance). In reality, exchange-traded products can experience tracking error.

Source: UVIX Prospectus (p.36)

Is There Options Trading on UVIX?

UVIX is a brand new product (inception date of March 30th, 2022) and does not yet have a liquid options market. Time will tell if the options market in UVIX improves.

Does UVIX Pay a Dividend?

No, UVIX does not pay a dividend.

Additional Resources

UVIX Prospectus

ETF vs. ETN vs. ETP vs. ETC

What is VXX and How Does it Work?

What is UVXY and is it Worth the Risk?

Chris Butler portrait

What is SVIX? (Short Volatility ETF Explained)

Posted on by Chris Butler

Last updated on March 29th, 2022 , 09:54 am

Volatility has become a tradable asset class due to the success of volatility ETPs such as VXX, SVXY, and UVXY.

SVIX is one of the newest products entering the volatility trading space.

What is SVIX and How Does it Work?

The -1x Short VIX Futures ETF (Ticker: SVIX) seeks to provide daily investment results, before fees and expenses, that correspond to the Short VIX Futures Index (Ticker: SHORTVOL).

SVIX aims to return the inverse of the daily percentage changes of near-term VIX futures.

The inception date of SVIX is scheduled to be March 30th, 2022. Volatility Shares is the issuer of SVIX.

Let’s explore the Short VIX Futures Index mentioned in the product description to learn how SVIX works.

What is the Short VIX Futures Index (SHORTVOL)?

The benchmark SVIX tracks is the Short VIX Futures Index (SHORTVOL) by Cboe.

Index Methodology: SHORTVOL tracks the daily inverse performance of a theoretical portfolio of first and second-month VIX futures contracts that are rolled daily. The portfolio aims to hold a mixture of the two futures to achieve a weighted average of 30 days to settlement.

If it is February 1st, the first-month VIX future will be the February contract, and the second-month VIX future will be the March contract.

The Short VIX Futures Index (SHORTVOL) tracks the inverse daily percentage changes of a theoretical portfolio of first and second-month VIX futures.

VIX futures track the Cboe Volatility Index (the VIX Index), which increases during times of heightened market volatility and falls during calm market periods.

A short VIX futures position profits when the:

  • VIX index falls to lower levels, pulling VIX futures contracts lower with it.

  • VIX futures curve is in contango, causing short-term futures to trade lower as they converge towards the lower VIX index (contango bleed).

The SHORTVOL index will therefore increase during falling or persistently low volatility market conditions.

Bullish SVIX traders are effectively short Cboe volatility index futures.

Bearish SVIX traders are effectively long Cboe volatility index futures.

SHORTVOL Movement Examples

The past performance of the SHORTVOL index informs us about how SVIX should perform under various market conditions:

SHORTVOL index past performance.

During extended periods of low volatility, SVIX can increase exponentially as it captures continuous positive daily percentage returns from the decaying VIX futures.

Consequently, the share price of SVIX can compound, as SHORTVOL did during the persistently low volatility of 2016 and 2017:

SHORTVOL performance from 2016 to early 2018.

From January 2016 to January 2018, SHORTVOL went from the low 300s to 2,800, an increase of 833%. SVIX would have experienced a similar return.

But during periods of surging market volatility, SVIX will likely lose substantial value. The faster the increase in volatility, the larger the drawdown SVIX will experience.

In early 2018, the popular short volatility ETF, SVXY, lost over 90% of its value after market volatility spiked:

SVXY collapsed 90%+ in early 2018.

Source: Google Finance

The short volatility product XIV was terminated following the collapse. SVXY’s leverage was reduced from -1x to -0.5x.

SVIX is the new -1x volatility product, restoring the previously accessible -1x leverage to the short volatility product space.

While SVIX may experience exponential returns during prolonged periods of low volatility, all of its value can be lost in the event of a massive short-term spike in volatility.

What is the Difference Between VIX and SVIX?

The VIX cannot be traded directly. SVIX allows inverse exposure to changes in the VIX index through the VIX futures market.

The Cboe VIX Index is a calculation of market implied volatility using S&P 500 Index options with around 30 days to expiration.

The VIX index cannot be traded as there are no underlying shares. It is only a calculation.

To trade anticipated changes in the VIX index, traders turn to VIX futures and options.

Trading VIX futures is a risky endeavor, as one VIX futures contract represents $1,000 per point in notional value (a large position). A 10-point move in a VIX futures position translates to a P/L of $10,000 on one contract.

SVIX is an ETF that tracks the SHORTVOL index, which tracks -1x the single-day percentage changes of the first and second-month VIX futures contracts.

For instance, if it is February 1st, SHORTVOL will track -1x the single-day percentage changes of a mixed portfolio of February and March VIX futures contracts.

SVIX is a volatility product that allows traders to gain exposure to changes in the VIX index through the futures market.

VIX Index <= VIX Futures <= SVIX

What is the Difference Between UVIX and SVIX?

UVIX, the 2x Long VIX Futures ETF, seeks to provide daily investment returns, before fees and expenses, that correspond to twice the performance of the Long VIX Futures Index (LONGVOL).

UVIX is a 2x leveraged long volatility product.

UVIX aims to return 2x the daily percentage change of a portfolio consisting of first and second-month VIX futures contracts.

Read our full guide on UVIX.

SVIX, the Short VIX Futures ETF, seeks to provide daily investment returns, before fees and expenses, that correspond to the performance of the Short VIX Futures Index (SHORTVOL).

SVIX is a short volatility product.

SVIX aims to return -1x the daily percentage change of a portfolio consisting of first and second-month VIX futures contracts.

UVIX is a 2x (leveraged long) volatility ETF. SVIX is a -1x (short) volatility ETF.

How Risky is SVIX?

SVIX is a high-risk volatility product.

SVIX should not be held as a long-term “investment.” Buying shares of SVIX does not represent ownership of any business, unlike buying shares of SPY.

During calm market periods where the VIX futures are in contango, SVIX will gain value steadily.

The investment strategy of holding SVIX shares during low market volatility can produce incredible returns, but not without the risk of catastrophe.

In the event of a short-term volatility spike, SVIX can lose all or most of its value, as XIV and SVXY did during the “volmageddon” in 2018.

SVIX is designed for short-term stock and options trading, not long-term investing.

Additionally, the complex nature of SVIX can cause uninformed traders to lose money due to a lack of understanding of the product’s mechanics.

I do not recommend making any trades in SVIX unless confident in your understanding of how it works, and the risks of your specific trades.

How is SVIX Calculated?

SVIX is benchmarked to the Short VIX Futures Index (SHORTVOL).

SHORTVOL tracks the daily inverse performance of a theoretical portfolio of first and second-month VIX futures contracts that are rolled daily.

Each day, the net asset value (NAV) of SVIX should correspond to:

Previous Closing Price + Current Trading Day’s SHORTVOL Change (%)

Example: SVIX closes at $50 on Monday.

On Tuesday, if the SHORTVOL index increases by 3%, SVIX shares should trade at $51.50 ($50 x 1.03).

Conversely, if the SHORTVOL index falls by 10%, SVIX shares should fall to $45 ($50 x 0.90).

The above examples represent no tracking error (perfect tracking of index performance). In reality, exchange-traded products can experience tracking error.

SVIX tracking objective.

Source: SVIX Prospectus (p.36)

Is There Options Trading on SVIX?

SVIX is a brand new product (inception date of March 30th, 2022) and does not yet have a liquid options market. Time will tell if the options market in SVIX improves.

Does SVIX Pay a Dividend?

No, SVIX does not pay a dividend.

Additional Resources

SVIX Prospectus

ETF vs. ETN vs. ETP vs. ETC

What is VXX and How Does it Work?

What is SVXY and How Does it Work?

Chris Butler portrait

What Is a Cash-Secured Put? Get Income or Cheap Stock

Posted on by Mike Martin

Last updated on May 6th, 2022 , 03:49 am

Cash Secured Put Chart

The cash-secured put is a risk-defined options trading strategy that involves the sale of a put option while holding funds on reserve to purchase the stock if/when assignment occurs.

The cash-secured put (also known as the cash covered put) options strategy is attractive to investors for two reasons: 

1.) The cash-secured put provides investors with a steady stream of income. 

2.) When/if assigned, cash-secured puts allow investors to purchase desirable stocks at a discount. 

The cash-secured put has a lot in common with the short (naked) put, with one major exception: the seller of cash-secured puts does not fear the stock falling in value, as it is their intent to purchase the stock at a discount via the exercise/assignment process. 

In an environment of constant volatility and price, options decay in value. This time decay, known as “theta” is advantageous to both short call and put options. 

Let’s first break this strategy down by looking at its profile.

 

              TAKEAWAYS

 

  • The cash-secured put is a neutral to bullish options trading strategy.

  • In order for this trade to be “cash-secured”, the cost of the trade will be the cost to purchase 100 shares of the underlying stock at the strike price of the put sold.

  • The cash-secured put is an investment strategy that allows an investor to buy an attractive stock at a lower purchase price. 

  • If/when assigned, the short put will be replaced by 100 long shares of the underlying stock/ETF.

  • Traders who are very bullish on an underlying
     would be better off by simply buying the stock outright. 
Cash Covered Put

Market Direction

All Market Directions (depending on trade intent)

Trade Setup

Short 1 ATM/OTM Put Option 

Maximum Profit

1.) On the short put, max profit is the credit received.

2.) If assigned to stock, max profit is unlimited. 

Maximum Loss

1.) On the short put, max loss is strike price minus the premium received.

2.) If assigned to long stock, the max loss is unlimited. 

Breakeven Point

Strike price minus the premium received for the put.

Trade Cost (Margin)

Cash Account: (strike price) × (number of contracts) × (option multiplier)

Margin Account: Varies by broker (lower than cash account)

What are Cash Secured (Covered) Puts?

The cash-secured put strategy has two components:

1.) Selling a put option contract

2.) Setting enough money aside to purchase stock at the strike price of the put should assignment occur. 

Determining the “moneyness” state of the put option you wish to short is subjective. Generally speaking, the strike price of put options sold in this strategy will be either:

1.) At-The-Money

2.) Out-Of-The Money

The cash-secured put is unique in that most traders of this strategy want their option to be assigned. This allows the stock to be purchased at a lower cost basis. 

However, even if assignment does not occur, the income from selling the put will still be collected, resulting in a win-win scenario. 

For example, if Ford stock (F), is trading at $15/share, and an investor wished to buy this stock at $13/share, that investor could sell the $13 put option at a later expiration cycle. 

If the stock closes above $13/share at expiration, the option will expire worthless. 

If the stock is trading below $13 at expiration, the short put will be assigned, and that investor will purchase 100 shares of F stock at the lower price of $13/share.

Cash Secured Put Risks

Risk #1:

We mentioned before that the cash-secured put is often a “win-win” trade. This does not mean that there is no risk in this options strategy. 

Most of the time, traders utilize this strategy when they want to purchase a stock at a discount from its current market price. If the stock price remains neutral, a trader will receive income from the option(s) sold. If the stock price declines below the strike price by expiry, that trader will purchase the stock at a better price.

But what if the stock is neither neutral or bearish, but bullish?

Cash Secured Put Chart

A trader could very well miss out on the price appreciation of a stock while waiting for it to fall in value, collecting only a relatively small amount of income from the put option sold. 

Risk #2

The second risk that the cash-covered put introduces pertains to the option itself. If a trader sells a $15 strike put, but that stock crashes to $10 in value, that trade will result in significant losses. Cash-secured puts are rarely sold on stocks that experience high volatility or this reason. 

Sure you’ll buy the stock for cheaper, but you’ll also lose a ton of money on the option. The “wait-and-see” approach is best for more volatile stocks. 

But enough theory, let’s see the cash-covered put in practice!

Cash Secured Put Trade Example

In this trade example, we are going to look at a cash-secured put on GoPro (GPRO). I prefer to use this strategy on cheap stocks. The cost of the trade is low, and if assignment occurs, it won’t eat up all your cash to hold the 100 shares.

Trade Details:

➥ GPRO Stock Price: $8.40

➥ Put Option Strike Price: 8

➥ Credit Received: 0.25

➥ DTE (Days to Expiration): 35

➥ Breakeven: $7.75 (Strike Price – Premium)

➥ Maximum Potential Profit: 0.25 ($25)

➥ Maximum Potential Loss: $775 (Strike Price 8 – Premium 0.25)

 

We are next going to examine this trade through two different outcomes; one will be a desirable outcome, the next outcome will be less than desirable. 

Cash-Secured Put: Outcome #1

Trade Details:

➥ GPRO Stock Price: $8.40 –> $7.50

➥ Put Option Strike Price: 8

➥ Put Value: 0.25 –> 0.50

➥ DTE (Days to Expiration): 0

 

Cash Secured Put at expiration 5

In this trade outcome, the price of GPRO has fallen in value below the strike of our short put. If at the expiration date the stock price is below the short put strike, you will be assigned. The below image shows the exercise/assign process:

Assignment/Exercise Process

In The Money Option at Expiration

Here are the sequential steps that will happen to our GPRO trade if our option is in-the-money at expiration.

1.) The long party will exercise their long put option and receive -100 shares of stock; the short party (us) must therefore deliver this stock at $8/share. 

2.) Our short option is replaced by 100 long shares of GPRO stock for a cost of $800 (the true cost of this trade is $775 since the trade took in $25 in premium).

3.) If funds are not available to hold this stock, an account will be either placed in a margin call or liquidated. 

For cash-secured puts, the third outcome rarely happens. Why? Cash-secured means that a trader already has the funds placed on reserve to hold the stock. They are anticipating this to happen.

Cash-Secured Put: Outcome #2

Trade Details:

➥ GPRO Stock Price: $8.40 –> $10

➥ Put Option Strike Price: 8

➥ Put Value: 0.25 –> 0

➥ DTE (Days to Expiration): 0

Cash Secured Put at expiration no assignment (1)

In this trade outcome, the stock has risen well above our short strike price at expiration. This means there is zero chance of assignment. 

The good news? This trade collected the full premium of 0.25 ($25).

The bad news? We would have made a lot more money if we had just purchased the stock!

At the time of trade origination, the stock was trading at $8.40. At expiry, it was trading at $10/share. 

Had we just bought 100 shares of stock initially, we would have made $160 ($1.60 x 1 00) which is significantly less than the $25 we actually made. 

How Much Money Do You Need for a Cash Secured Put?

Cash-Secured Puts Trade Cost: (strike price) × (number of contracts) × (option multiplier)

For any account type, trading cash-secured puts is a costly endeavor. 

Cash-covered puts are backed 100% by cash. The cost of the trade is the cost to purchase the stock at the strike price. This means that if a stock plummets to zero, a cash-secured put trader already has those funds in their account to cover these losses. Let’s look at two examples:

➥AMZN: Short 2700 Put for $2 

amzn cash secured put buying power

So in this scenario, we must have the cash to purchase 100 shares of AMZN stock at $2,700/share. That’s a cost of $270,000. 

We can reduce the credit from this cost, but that credit is very small in the scheme of things, resulting in a true cost of $269,800

One of the great disadvantages of the cash-secured put is opportunity cost: what else could you be doing with that money? 270k is a lot of money to have on the sidelines! This is particularly true when you factor in the average return of the S&P 500 is over 10%/year.

That’s why cash-secured puts are usually sold on cheaper ETFs and stocks:

➥NOK: Short 4 put for $0.25

nok buying power

Sure you can only make $25 here, but the cash requirement for this cheap trade is only $400, or $375 when taking into account the option premium already received.  

Is a Covered Put the Same as a Cash Secured Put?

The cash-secured put is NOT the same strategy as the covered put.

While the cash-secured put is simply a short put option, the covered put option strategy consists of:

  • 100 Short Shares of Stock
  • Short One Put Option

The product of these two positions makes the covered put a bearish options strategy.

The cash-secured put is a neutral/bullish options strategy.

Additionally, the covered put strategy has unlimited risk, while the cash-secured put has defined risk. 

The below image shows the profit and loss of a covered put trade at expiration.

Covered Put Chart

covered put vs short stock

Are Cash Secured Puts a Good Strategy?

So is the cash-secured put a good strategy? Like everything in options trading, that depends on the performance of the underlying!

If you are neutral to bearish in the short term, but bullish in the long-term, the cash-secured put is a great strategy to purchase an attractive stock or ETF at a discount. 

If you are bullish in the short-term, you best bet is to avoid this strategy and simply purchase the stock. 

Cash-Secured Put + Covered Call Strategy = The Wheel

Some traders like to utilize both the cash-secured put trade and covered call options strategy in sequential order. This is known as “The Wheel” options trading strategy. 

The Wheel strategy involves always being short an option. Once the short put is assigned, a trader would then proceed to sell a call against the long shares.

Here’s how that process works:

Cash Secured Put and Covered Call

Can I Sell Put Options in My IRA?

The cash-secured put is a risk-defined trade and therefore permittable in both IRA accounts and cash accounts. 

However, just because the trade is allowed in these account types does not necessarily mean your broker will permit them.

Because of the risks that options trading introduces, many brokers limit or outright ban options trading in retirement accounts. 

However, a few trader-focused brokers, like tastyworks, allow options trading in IRA accounts.

Cash Secured Put vs Short Put

The cash-secured put is essentially the same trade as the naked put. The only difference is the cost of the trade.

Consider the cost of the below two short puts trades in FB, where one is done in an IRA account and the other done in a margin account:

 

Cash-Covered Put: Margin Account

Cash-Covered Put: IRA Account

cash secured put IRA

As we can see, the cost of this trade is significantly higher in IRA and cash accounts than margin accounts. Why? IRA accounts don’t allow you to trade options on margin. 

One of the greatest risks that come with the cash-covered put is opportunity cost. What else could you be doing with that 20k while you are waiting to collect a small premium?

 

Back to All Strategies ➥

Cash Secured Puts FAQs

To close a cash-secured put, simply create the opposite order that was used to initiate the trade. If no action is taken and the cash-secured put is out-of-the-money at expiration, the short put will expire worthless. If the short put is in-the-money at expiration, the short put will be assigned 100 long shares of stock.

If the stock on which a put is sold increases in value, a short put option will decline in value, resulting in profits. If the stock is above the strike price of the put sold by expiration, the put option will expire worthless. 

The cash-secured put is a relatively safe strategy. At trade initiation, the full cost of the trade, or the maximum loss potential, is staked by the investor. This makes the cash-secured put a defined-risk trade. 

Next Lesson

Money 101: The Functions & Characteristics of Money

Posted on by Chris Butler

Last updated on April 25th, 2022 , 11:18 am

Money is at the core of almost everything we do.

Unless you live in the wild and fully support yourself, you use money.

In this guide, you will deepen your understanding of money by exploring the:

  • Functions of money
  • Characteristics of money
  • Evolution of money

Let’s begin!

What is Money?

According to the Merriam-Webster definition, money is generally accepted as a medium of exchange, a measure of value, or a means of payment.

So “money” is:

– Recognized by society as being an acceptable form of payment for things

– People can value goods/services in terms of money

The combination of these things means:

#1: I can walk into a U.S. grocery store and buy food with U.S. dollars, the recognized and acceptable form of currency in the United States.

#2: I can assess how valuable things are by comparing their values in a common unit of measurement (if a bottle of wine is $20, and a car is $20,000, I know the car is more valuable than the bottle of wine).

But it wasn’t always like this.

Thousands of years ago, the barter system (trading goods for goods) was the primary method of exchange.

If I made pots and you made blankets, I could trade you a pot for a blanket:

Goods/Services ⇒ Goods/Services

In a barter system, people trade goods for other goods. There is no medium of exchange to facilitate trade.

The barter system is inefficient because of the double coincidence of wants. For a trade to happen, each person must want what the other has to offer.

This is where modern money came to save the day.

By having a common thing that society recognizes, values, and demands, trade can occur between two parties even if they don’t want the goods/services the other has to offer.

We call the collectively recognized and valued thing money.

What Does Money Really Represent?

One of the most profound things I’ve come to understand about money is it is effectively stored energy.

Money we earn represents our life/labor energy.

We spend time and energy working to earn money to spend, save, or invest.

We convert our time and energy into money that we can later convert into a good or service.

Time and Energy Spent Working ⇒ Money ⇒ Goods/Services

Money represents our time and energy because we spend time and energy working and receive money in exchange.

Throughout history, money has taken many forms: shells, salt, sticks, stones, coins, paper, and now, digital money like digital USD and bitcoin.

The specific types of money have evolved over thousands of years as better forms of money emerged.

What makes a form of money better than another? We will explore that shortly.

The 3 Functions of Money

Regardless of the form of money (gold coins, paper notes, bitcoin) there are three primary functions of money:

  • Medium of Exchange

  • Store of Value

  • Unit of Account

Let’s explore each of these money functions with examples.

Money serves as a medium of exchange, store of value, and unit of account.

Medium of Exchange

The first function of money is a medium of exchange, or a common item that people use to carry out transactions.

Example: I go out to dinner and pay the restaurant U.S. dollars (USD) for my food.

Money (USD) ⇒ Dinner

The restaurant takes my dollars and pays their suppliers for ingredients and staff for serving me.

Money (USD) ⇒ Restaurant Supplies + Payroll

The staff takes their dollars and exchanges them for food, clothes, and shelter.

Money (USD) ⇒ Food, Clothes, and Shelter

Having a medium of exchange makes trade much more efficient because I can pay someone money for goods/services, which they accept because they know someone else will accept that same money for goods/services (money has constant demand).

If the people in a society all recognize and value a common medium of exchange, those people pay and receive payment in that medium of exchange.

In the United States, the recognized medium of exchange is the U.S. Dollar (USD).

In the eurozone, the recognized medium of exchange is the euro.

In El Salvador, the recognized mediums of exchange are USD and bitcoin.

A medium of exchange is a common item societies use to exchange value and facilitate trade.

Store of Value

The second function of money is serving as a store of value (preserving value across time).

The benefit of having a store of value is that we don’t have to spend our money immediately if we have no wants or needs.

With no immediate wants or needs, we can save or invest our money to spend it in the future by holding it in a store of value.

Without a store of value, we have to spend our money immediately, even if we don’t have anything we need to buy. Without a store of value, we increase wasteful spending and can’t save for the future.

Ideally, money serves as a store of value by preserving purchasing power over time. As we’ll see in a later section, this hasn’t been the case for modern money over long time periods.

A store of value preserves the purchasing power of money over time.

What Makes a Good Store of Value?

A good store of value will preserve (or grow) purchasing power over time.

Purchasing power is how much stuff I can buy with my money.

If $100 in my bank can buy 100 widgets today and 100 widgets a year from now, the money holds its purchasing power and is a fantastic store of value.

Stable/Growing Purchasing Power Over Time ⇒ Great Store of Value

A good store of value preserves the purchasing power of money over time (how much stuff money can buy).

If $100 in my bank can buy 100 widgets today but only 50 widgets a year from now, the money loses purchasing power and is not a store of value.

Loss of Purchasing Power Over Time ⇒ Bad Store of Value

A bad store of value results in loss of purchasing power over time (money buys less in the future as compared to today).

The store of value function is critical to the success of a form of money.

If a money does not hold its purchasing power over time, its users are encouraged to spend their money sooner than later because they will be able to buy less in the future compared to now. Rapid loss of purchasing power prevents people from saving money for future consumption.

Additionally, those selling goods/services may be hesitant to accept something that doesn’t hold its purchasing power over time.

For instance, if I I’m selling a $1,000 item, I’ll be hesitant to accept $1,000 worth of bananas instead of $1,000 in gold.

The bananas will perish within a week and render the entire sale worthless.

The gold doesn’t spoil, and I can hold it comfortably for an extended period of time. It may even appreciate!

Unit of Account

The third function of money is acting as a unit of account (common measure of value).

With a common unit of measurement, we can easily track changes in wealth and compare the prices of goods/services.

If a cup of coffee is $5 and a bottle of wine is $100, I know the bottle of wine is more valuable than the coffee.

But if the coffee is $5 and the bottle of wine is 100 shells, it’s not clear which item is more valuable because the measure of value is different.

A unit of account allows us to compare the values of goods with a standard unit of measurement.

This is why it’s confusing traveling to foreign countries: they have a different unit of account than you’re used to, making it hard to understand the value of things. Is 10,000 yen a lot of money? How much are 25 pesos worth in USD? Confusing!

We’ve now explored how money serves as a:

  • Medium of exchange
  • Store of value
  • Unit of account

Technically, anything can be money, so what explains why money has changed forms so many times over the millennia?

The 8 Characteristics of Money

A new form of money should be graded on a basket of characteristics.

Something with high grades in all money characteristics is a better form of money than something with high scores in only a few of the characteristics.

The market will ultimately choose the best form of money—the one with the highest cumulative ranking in all characteristics of money.

What are these characteristics?

Durable

Money that is durable (difficult to destroy) is safer to possess than fragile money. Durability exists in a physical and digital sense.

Wine glasses would be a poor form of money because they are fragile. If your wealth is stored in wine glasses and a bulldozer drives over them, you’re toast.

Gold is virtually indestructible (A+ durability), which is one reason it has stood the test of time as a widely recognized store of value.

If your house was burning down, it would be better to have bars of gold under your mattress as opposed to piles of dollar bills.

Gold is, therefore, more durable than paper money.

Money needs to be durable to protect the wealth of those holding it.

Durability exists in a digital sense too.

For example, bitcoin has no physical form, but it is incredibly durable. So how can digital money be durable?

Bitcoin is entirely digital money requiring the entire history of transactions to keep track of who owns what.  If the entire bitcoin ledger (transaction history) was stored on a single computer, the wealth of every user could be erased by destroying the computer storing the ledger (no history of transactions = no way to verify ownership).

Fortunately, the bitcoin ledger is stored and updated on a global computer network consisting of tens of thousands of computers.

Simultaneously destroying every computer storing bitcoin’s transaction history is virtually impossible, making bitcoin highly durable.

Digital money is only durable if the history of transactions is difficult to alter or destroy. Digital currency networks accomplish durability by maintaining copies of the ledger on thousands of computers across the globe.

Fungible

Money needs to be fungible, or interchangeable with other identical units without loss of value.

Government-issued currencies are highly fungible because it doesn’t matter which $1 bill you have.

If I have $1 and you have $1, we can exchange the notes and be in equal standing.

Money must be fungible, or interchangeable with other identical units.

When gold and silver coins were used as currency, fungibility would be a problem in a scenario where my gold coin was 95% pure while your gold coin was 90% pure. I wouldn’t want to give you my 95% gold coin for your 90% gold coin, even if they were marked the same and supposed to be of equal value.

Even if the coins were marked similarly and said to be equal, they wouldn’t be fungible because of the differing purities. Additionally, early forms of precious metal coins likely differed in shape and size, decreasing fungibility.

If various “identical” units of money are deemed more valuable than others, the money becomes less acceptable than a fully fungible form of money and will not move as freely through the economy.

Divisible

Money that is highly divisible allows for accurate payments of any value.

Without divisibility:

  • Value is lost through inaccurate exchanges.

  • Small exchanges don’t happen at all

For instance, if our minimum denomination was $5, I could not accurately pay for something worth $7. I’d have to pay $10 and overpay by $3 or the merchant would have to accept $5 and lose $2.

U.S. currency is divisible because each $1 consists of 100 units called pennies.

Bitcoin is divisible because each unit is divisible into 100 million units called satoshis (sats).

Money needs to be divisible to allow for payments of all sizes.

It doesn’t matter if a good is worth $1.23 or 0.0003 BTC, I can pay the exact amount because U.S. dollars and bitcoin are highly divisible.

Portable

Money must be portable so that it can move around easily.

A gold bar is not very portable because it’s big and heavy. Not to mention it’s not very divisible either! Therefore, a gold bar is not great day-to-day money.

The introduction of paper currencies convertible to gold made money more portable because paper is light and flexible. It’s easier to carry around a piece of paper that represents $100 in gold than $100 in physical gold.

Today, money is more portable than ever because it is mostly digital.

Money must be portable so it can be moved around easily. Digital money is the most portable.

Portability doesn’t only involve moving money physically, but how easily it can move across borders.

Digital USD is portable within the USA, but less so internationally. There are restrictions on where I can send USD in the world, and it may take days.

Bitcoin is digital and borderless. BTC can be sent anywhere in the world without permission from financial gatekeepers.

Therefore, digital USD is highly portable within the USA but is less portable than BTC in terms of sending global payments.

Verifiable

Money must be verifiable to become counterfeit-resistant.

If the authenticity of money cannot be verified, the potential for counterfeit increases.

Government-issued currencies are verifiable from the serial numbers and intricate markings that appear on each unit of currency, providing them with strong counterfeit-resistance.

Bitcoin cannot be spent without access to the private key associated with a bitcoin wallet. Bitcoin’s ledger, or history of transactions, is public, making it easy to verify any transaction.

Money must be verifiable to become counterfeit-resistant.

Scarce

Scarcity is a critical characteristic of money because it is essential to the value of money over long periods of time. Everything that is valuable is scarce.

Your life is valuable because it has a time limit.

The Flying Fox yacht is valuable because there are few 450-foot luxury yachts in the world.

Gold is scarce because we must go through the time-intensive and costly process of digging it out of the ground.

Scarcity is essential to the preservation of value over time.

Limited supply and/or costly production improve scarcity.

Money must be scarce to preserve its value over time. Scarcity comes from limited supply and/or high cost of production.

Resistant to Confiscation and Censorship

Lastly, money should be resistant to confiscation (theft) and censorship (control of how money is used).

If a money is easy to confiscate, people are not safe storing their wealth in it.

After all, money represents our blood, sweat, and tears. If our money is confiscated, our life energy is stolen. Similarly, if our payments can be censored, we aren’t free to spend our money how we’d like to.

Different forms of the same money can be more or less resistant to confiscation and censorship.

For example, physical dollars can easily be stolen by a thief, which is why most people store their money at commercial banks and access it digitally.

Physical money is censorship-resistant because only the carrier of physical money can choose how it is spent/moved.

Digital dollars are much harder to steal, but are much less resistant to censorship (a bank can reject a credit card payment or wire transfer).

The Acceptability of Money

The characteristics of money make it more acceptable.

Money is the most “salable” good in an economy, or the easiest to sell.

Why? Everyone wants money because they can use it for anything.

Since money is highly demanded, it’s easy to sell (which is what you do when you buy something).

A money ranking high in all money characteristics will be more demanded than a money ranking poorly in the money characteristics.

Example: a form of money that is durable, scarce, divisible, portable, and verifiable will be more salable/demanded/acceptable than money that has low rankings in these characteristics.

Commodity Money vs. Representative Money vs. Fiat Money

Money has evolved over many thousands of years.

In the past, commodity money was the norm, which is money that derives value from its material, such as gold and silver coins.

Commodity money like gold and silver coins have intrinsic value because gold and silver are valuable.

Commodity money is inherently lacking in portability, verifiability, and fungibility. It’s inefficient to carry around a pouch of precious metals (not portable), they can be counterfeited (difficult to verify) and come in varying shapes and sizes (not fungible).

To improve the characteristics of commodity money, the world introduced representative money, which is money that is backed by something, such as gold.

An example of representative money would be a currency note convertible to a specified amount of gold.

Instead of carrying around gold coins, people could carry around paper notes representing convertibility to gold coins, increasing portability, verifiability, and fungibility.

Paper notes convertible to gold was the case under the gold standard.

Eventually, fiat money became the global standard, which is money that derives its value from government order.

A $20 bill (USD) is an example of fiat money. It has no intrinsic value because it’s only a piece of paper. But a $20 bill is valuable because the government says it has value, and it is legally recognized as currency in the United States, providing it with constant demand.

What is Legal Tender?

An emerging form of money may have high ranks in the characteristics of money, but that doesn’t mean it will be immediately and widely recognized as money.

Legal tender is a form of money that is legally recognized as an acceptable form of payment in a country.

 
However, individuals and businesses can choose to accept forms of money that are not designated as legal tender.

The U.S. dollar is legal tender in the United States, while the peso is legal tender in Mexico.

In September 2021, El Salvador became the first country in the world to begin recognizing bitcoin as legal tender, making it a widely accepted currency in the country.

The Problems With Fiat Currencies

While fiat money such as the U.S. dollar ranks well on many of the characteristics of money, it falls short in the scarcity category. And, centrally-controlled monies can be censored, cutting out users from the financial system.

Fiat currencies do not have limited supply because governments control their country’s monetary policy, or how the money supply of their currency is managed.

The Federal Reserve is the institution that controls the monetary policy in the United States.

Centralized control of monetary policy allows for quick action in regards to the money supply, but not without consequences.

Central banks can create more units of currency instantly and without cost, like changing a number in a spreadsheet.

If the supply of money rises quickly, each unit of currency is susceptible to loss of purchasing power (more units required to buy the same amount of goods and services).

Currencies can lose purchasing power rapidly in the case of severe mismanagement of a nation’s currency.

Over time, the U.S. dollar has lost purchasing power. The longer the time period, the greater the loss of purchasing power.

Here’s a graph from the U.S. Bureau of Labor Statistics of the purchasing power of the U.S. dollar since 1913:

Purchasing power of the US dollar from 1913-2022.

While there have been periods of increasing purchasing power, the long-term trend is down.

According to Visual Capitalist, $1 in 1913 could buy 30 Hershey’s chocolate bars, but only one McDonald’s coffee in 2020:

A table showing the purchasing power of $1 in various years since 1913.

To provide more context, according to usinflationcalculator.com, $1,000 in 1913 had the same purchasing power as $28,658 in 2022:

U.S. inflation from 1913 to 2022 was a cumulative 2,765%.

In other words, if you held $1,000 in a bank account during that period and didn’t grow it, your $1,000 in 2022 is nearly worthless compared to what it could buy in 1913.

You needed to grow each dollar 28x to maintain purchasing power since 1913. Any returns lower than a 28x resulted in lower purchasing power.

We can compare the purchasing power loss of the U.S. dollar to the US money supply since the late 1950s:

US dollar supply (M2) from 1950s to 2022.

Source: Trading Economics

The U.S. dollar has lost almost all purchasing power since the early 1900s as the Federal Reserve printed more of them.

Some economists argue that an increase in the money supply doesn’t cause inflation.

As I write this, the Federal Reserve is printing money (increasing the money supply) faster than ever before, and CPI inflation is at 7.9% year-over-year (as of Feb 2022), the highest in 40 years.

Other countries have experienced hyperinflation, which is essentially a currency failure because prices are rising so fast (higher prices = lower purchasing power).

The Zimbabwe dollar is one example of a currency that became worthless due to hyperinflation, which isn’t surprising when we look at the changes in the money supply:

Zimbabwe money supply (M2)

Source: Trading Economics

The conclusion is that fiat currencies are not long-term stores of value. Historically, long-term holding periods of fiat currencies has led to significant loss of purchasing power.

While fiat money is efficient for short-term saving and spending (and required for payment of federal taxes) investors seeking to preserve/grow their purchasing power over time need to allocate money to other financial assets such as stocks, real estate, precious metals, or bitcoin.

Conclusion

Money serves a critical role in modern economies:

1) It serves as a medium of exchange, allowing for more trade to occur by removing the double coincidence of wants (two parties simultaneously wanting the good or service the other has to offer).

2) It serves as a unit of account or common measure of value, allowing for societies to easily understand the relative costs of things and keep track of changes in financial accounts.

3) It serves as a store of value, allowing us to preserve purchasing power (though not over long periods of time in the case of fiat currencies) and not spend all of our earnings immediately.

But not all forms of money are good.

The best forms of money rank high on a list of characteristics: durability, fungibility, divisibility, portability, verifiability, scarcity, and resistance to both confiscation and censorship.

Over the millennia, money has evolved and taken many different forms, each time advancing to a new form of money with better overall rankings in monetary characteristics.

Fiat currencies are the current global standard, as they rank high in most monetary characteristics.

Unfortunately, the history of fiat currencies shows that they fail as a store of value over time due to their unlimited supply and zero cost of creation, deteriorating the wealth of those confined to them.

Additionally, users of centrally-controlled currencies are subject to the mismanagement of the money supply and financial censorship.

Will the emergence of digital money like bitcoin, following rules of code that aren’t controlled by a central authority, be the next global standard for money?

Or will we remain on a fiat standard for centuries to come?

Time will tell.

One thing is likely: money will continue evolving over time as superior forms of money come into existence.

I truly enjoyed putting this piece together, and I hope it was insightful and succeeded in deepening your understanding of money.

Chris Butler portrait

Long (Bull) Call Ladder Options Strategy: Visual Guide

Posted on by Mike Martin

Last updated on April 7th, 2022 , 07:05 am

Long Call Ladder Spread
Bull Call Ladder

             TAKEAWAYS

 

  • The long call ladder (AKA bull call ladder) is comprised of a traditional long call spread with an additional out-of-the-money call sold.

  • Maximum loss on the long call ladder strategy is infinite.

  • Maximum profit for the long call ladder spread is Middle Short Strike Price – Strike Price of Long Call – Total Debit Paid.

  • Max profit occurs when the underlying security is trading between the strike prices of the two calls sold.

  • Due to the 1×2 long call to short call ratio, the margin is very high for all ladder trades.

The long call ladder (also known as the bull call ladder), is a moderately bullish options trading strategy.

The long call ladder has a lot in common with the bull call spread (long call spread), with a few very important differences.

The chief distinction between these two strategies lies in the risk involved. While the bull call spread is a defined risk strategy, the bull call ladder has unlimited risk. 

This unlimited risk lay in the structure of the ladder strategy, which consists of one long call and two short calls. Whenever you have unhedged calls, your risk is infinite.

Let’s break the strategy down!

Bull Call Ladder Profile

Long Call Ladder

Market Direction

Moderately bullish

Trade Setup

Long 1 ITM Call
Short 1 ATM Call
Short 1 OTM Call

Maximum Profit

Middle Short Strike Price - Strike Price of Long Call - Total Debit Paid.

Occurs when the price of the underlying asset is trading between the strike pries of the two short calls at expiry.

Maximum Loss

 Maximum Loss #1: When stock is below long call strike price at expiration, max loss is net debit paid.

 Maximum Loss #2: When stock rallies beyond the highest strike price sold, max loss is infinite

Breakeven Point

1.) Upper Breakeven: Upper Strike + Middle Strike - Lower Strike - Premium Paid

2.) Lower Breakeven: Long Call Strike Price + Total Debit Paid

Bull Call Ladder vs Bull Call Spread

The best way to understand the ladder strategy is by comparing it to the traditional bull call spread. 

The bull call spread is a bullish, defined-risk, limited profit options strategy. The below graph shows the profit/loss profile for this trade at expiration:

Bull Call Spread

The bull call spread consists of two call options: 

  • Long 1 Call Option at Lower Strike Price

  • Short 1 Call Option at Higher Strike Price

Since we are both long a call and short a call option in the same expiration date cycle, this strategy has defined risk: the most we can lose is the debit paid to enter the trade. 

But what if you believed a stock was indeed going to go up, but not past a certain level? Couldn’t you sell an additional call at this level in order to generate a little extra income from the trade?

In options trading, you can do whatever you want. You can combine as many calls and puts and expiration cycles as you desire. 

So what would this graph look like if we decided to add an extra short call at the end of this trade?

Long Call Ladder Visualized

The below image shows a traditional bull call spread with an extra short call added at the tail end. The result? The long call ladder (or bull call ladder).

Bull Call Ladder
  • Long 1 Call Option at Low Strike Price

  • Short 1 Call Option at Middle Strike Price

  • Short 1 Call at High Strike Price

I like to think of the bull call ladder as the greedy man’s long call spread. If you are not content with the maximum profit from the original call spread  (Strike Price of Short Call – Strike Price of Long Call – Net Premium Paid) you could sell an extra call.

This third short call must my further out-of-the-money than the first short call sold. 

As long as the stock stays between the strike prices of your short calls, you will achieve both the maximum profit from the original spread (equation above) and the credit received from that extra out-of-the-money call you sold. 

The downside? Your risk is now infinite, as illustrated in that downward-sloping red arrow in the above chart. 

Let’s take a look at an example next.

Long Call Ladder Trade Example

In this example, we are going to look at a long call ladder on Apple (AAPL) stock. Here are our trade details.

AAPL Long Call Ladder:

  • AAPL Stock Price: $170
  • Days to Expiration: 9
  • Long Call Strike/Debit: 170/$2.95
  • Short Call #1 Strike/Credit: 175 / $0.96
  • Short Call #2 Strike/Credit: 180 / $0.27
  • Net Debit: (2.95-0.96-0.27) = 1.72
  • Lower Breakeven: $171.72
  • Upper Breakeven: $183.28
  • Max Loss: Infinite
  • Max Profit: $328

So we bought the 170/175 call spread for $1.99 (2.95-0.96), then tacked on an extra short call for 0.27. This extra credit received reduced the cost of our trade by 0.27, bringing the new trade debit down to $1.72. Don’t get too overwhelmed by the numbers. 

Our maximum profit here is simply the width of the traditional call spread (5 points), minus the net debit paid (1.72). This gives us 5 – 1.72, or maximum profit potential of $3.28. 

Since we have a naked short call, our maximum loss is infinite on the upside, but limited to the cost of the trade on the downside. 

To help better understand our trade, let’s analyze it visually:

As we can see, we will achieve maximum profit when AAPL is trading between about 175 and 180 on expiration.

For breakeven, we can expand these bounds to $171.72 and $183.28.

Let’s fast-forward to expiration day and see how our trade did!

Winning AAPL Long Call Ladder at Expiration

  • AAPL Stock Price: $170 –> $175
  • Days to Expiration: 9 –> 0
  • Long Call Strike/Debit: 170/$2.95 –> $5
  • Short Call #1 Strike/Credit: 175 / $0.96 –> $0
  • Short Call #2 Strike/Credit: 180 / $0.27 –> $0
  • Spread Value (5 + 0 + 0) = 5

If on expiration day at the close AAPL is trading at $175, we will have achieved maximum profit on the trade of $328. Why?

Our long 170 call has increased in value from $2.95 to $5. That’s a profit of $205. Additionally, both of the calls we sold expired worthless (one was at-the-money at expiration, which we will call worthless for simplicity). The credit we received for these calls was $0.96 + $0.27. That gives us a credit received of $1.23, or $123.

So what is a profit of $205 plus a profit of $123? $328. 

But what if this trade didn’t go our way? What if AAPL kept rising inexorably in value? Let’s check out that trade outcome next.

Losing AAPL Long Call Ladder at Expiration

We said before that the long call ladder is a moderately bullish options trading strategy. This next hypothetical trade outcome will show why. Here, AAPL has risen in value to $190/share in value on expiration day.

  • AAPL Stock Price: $170 –> $190
  • Days to Expiration: 9 –> 0
  • Long Call Strike/Debit: 170/$2.95 –> $20
  • Short Call #1 Strike/Credit: 175 / $0.96 –> $15
  • Short Call #2 Strike/Credit: 180 / $0.27 –> $10
  • Spread Value (20 – 15 – 10)  $-5

Traditional bull call spreads are great because you always know your maximum loss scenario – the total debit paid. With long call ladders, this can be much more complicated – and risky. 

In this trade example, the short options in our trade have increased significantly in value. If we never added that extra 180 short call, we would have achieved a maximum profit on the traditional call spread component of our trade of $5 ($20-$15 = $5 profit).

But we did indeed sell that extra call. Its value at expiration was $10. That $10 must be subtracted from our profit of $5 on the call spread. The result is a negative spread value of $-5  on expiration. That means we lost $500 on the trade. 

Remember, our maximum profit in this scenario was only $328!

Theta (Time Decay) in Bull Call Ladder Spreads

The bull call ladder has a complicated relationship with the options Greek theta. 

Theta, or time decay, tells us how fast the value of an option declines on a daily basis in an environment of stable stock price and volatility. 

In the bull call ladder:

  • Theta is negative when the underlying is trading both below the lower breakeven and above the higher breakeven.

  • Theta is positive when the underlying is trading between these two breakeven prices.

Bull Call Ladder Spread: Choosing Strike Prices

Perhaps the most important part of trading options is choosing the right strike prices. 

For a lesson on choosing strike prices on vertical spreads, check out our article here. 

Once you determine the strike prices of the traditional call spread component of the ladder strategy, you must go one step further and choose the strike price of that last, very risky, out-of-the-money call option.

Here are three important reminders in your selection process:

  1. The further an option is sold out-of-the-money, the greater that option has of expiring worthless.

  2. Options sold closer to being in-the-money will result in a higher credit, thus a higher maximum profit potential for the ladder.

  3. Additionally, options sold closer to being in-the-money will have a lower probability of success that out-of-the-money options.

The below image, taken from the tastyworks trading platform, shows the traditional strike price layout on an options chain for a bull call ladder spread. But remember, you can get as creative as you want with options!

Traditional Bull Call Ladder Setup

Bull Call Ladder Strike Prices

Bull Call Ladder Spread: Pros and Cons

In order to adequately understand the pros and cons of the long call ladder, we must compare this strategy to the less sophisticated bull call spread. 

👍 Bull Call Ladder Pros

  • When compared to the traditional long call spread, the long call ladder spread expands the profit area by the credit taken in from the extra call.

    Bull Call Ladder Advantages

  • The long call ladder spread also has a lower breakeven price than the long call spread on account of the extra premium taken in.

👎 Bull Call Ladder Cons

  • When compared to the traditional long call spread, the long call ladder spread requires much more margin. This is because the highest strike price call is sold naked. 

Traditional 175/180 Bull Call BP Effect

bull call spread buying power effect

175/180/185 Bull Call Ladder BP Effect

Long Call Ladder Buying Power Effect
  • When compared to the traditional long call spread, the long call ladder spread requires much more margin. This is because the highest strike price call is sold naked. Opportunity costs must be taken into account when utilizing this strategy.

Bull Call Ladder Spread: Is It Worth It?

Personally, I do not believe the profit/loss profile of the bull (long) call ladder spread makes the trade worthwhile. 

What we can not quantify here is the anxiety one feels when being in a position that has unlimited loss potential. This is particularly worrying when the maximum profit is capped at a relatively low level. 

When you trade bull call ladder spreads, you are trading naked call option contracts. It is that simple. You can use stop loss orders on that extra short call to mitigate risk, but this by no means removes risk. 

In a nutshell, the bull call ladder is an advanced options trade, and best avoided by beginners.

How strong is your stomach?

*Before trading options, traders should read the Characteristics and Risks of Standardized Options, or the Options Disclosure Document (ODD).*

Back to All Strategies ➥

Next Article

Additional Resources

Quora: Bull Call Ladder Articles

The Pros and Cons of a SEP-IRA for Retirement

Posted on by Mike Martin

Last updated on March 30th, 2022 , 10:17 am

Pros and Cons of SEP-IRA

The best time to start saving for retirement was years ago, but the second-best time is now. If you’re seeking ways to squirrel away money for retirement, especially investment vehicles that offer significant returns over the years, you’ve probably encountered different options.

One such option is the SEP-IRA. Is a SEP-IRA a good option? Does it have any drawbacks?

Let’s discuss.

What is a SEP-IRA?

A SEP-IRA is a retirement account designed for employers and self-employed individuals. IRA stands for Individual Retirement Account, and SEP stands for Simplified Employee Pension.

What Is a SEP-IRA

In other words, it’s a retirement account aimed at individuals and small business owners as a simple vehicle for retirement that has fewer complications than a 401(k) or a traditional pension system. It’s a traditional non-ROTH IRA, which means the money you contribute is tax-deductible, and the disbursement in retirement is taxable as income.

SEP-IRA Eligibility Requirements

The SEP-IRA is not for everyone. Due to the investment rules with a SEP-IRA, they are best for small business owners with few or no employees and the self-employed.

Why? One rule. When contributing to a SEP-IRA, you must contribute an equal percentage to the accounts of your eligible employees. If you have ten employees, that can stack up quickly; conversely, if you have zero employees or work for yourself, you don’t have to worry about it.

The equal contribution rule is based on the percentage of compensation. If you pay yourself $100,000 and pay your one employee $50,000 and want to contribute 10% of your income to your SEP-IRA, that’s $10,000 to your account. The equal percentage contribution rule requires you to contribute 10% of the employee’s compensation to their account, which is $5,000. Note that this is a simplified example, but the general rule remains.

Eligibility Requirements

What are the eligibility requirements? To open a SEP-IRA, you must be either an individual with freelance income or a business owner with one or more employees. Note that a business owner with zero employees still counts themselves as one employee for this eligibility.

For employees, eligibility is based on income earned from the business. Eligible employees must be 21 or older and have worked for you for 3 of the last five years. Anyone meeting those requirements, and whom you have paid over $600 in a year between 2016 and 2020, or $650 from 2021 onwards, is eligible for a SEP-IRA. And by “eligible,” we mean “required”; you must open and contribute to employee SEP-IRA accounts if you have one for yourself.

Additionally, employees control their SEP-IRA accounts. You don’t get to make decisions about how they manage or use that money; you just have to contribute to it.

SEP-IRA accounts also have much higher contribution limits than traditional IRAs. A traditional or ROTH IRA typically has a contribution limit of around $6,000 (this changes from year to year; it was $5,500 in 2018 but was increased to $6,000 in 2019 and beyond).

In contrast, a SEP-IRA has a contribution limit of $61,000 in 2022, over 10x as much. However, there is a second limitation; contribution cannot exceed 25% of compensation. If you’re paying yourself $100,000, you cannot contribute more than $25,000 to your SEP-IRA account.

What Are the Benefits of a SEP-IRA?

The SEP-IRA is a powerful investment vehicle for small businesses and individuals, with many benefits. What are they?

1. Much Higher Contribution Limits

One of the most significant benefits of a SEP-IRA is the higher contribution limits. Taking 2022 as an example, you can contribute up to $6,000 to a traditional or ROTH IRA account. However, with a SEP-IRA, you can contribute over 10x as much… assuming you make enough money to do so. The 25% of compensation limit also kicks in. Anyone making less than $24,000 per year will have a lower contribution limit than a standard IRA.

SEP-IRA Contribution Limits

Essentially, for anyone making between $24,000 and $300,000, give or take, a SEP-IRA can save much more money, much more quickly, than with another form of IRA. The increased contribution limits can be highly beneficial, particularly if you’re in your 30s or 40s and have relatively little savings in retirement funds. In a sense, it’s a way to “catch up” on investing.

2. Easy to Set Up and Manage

In most cases, setting up a SEP-IRA is as simple as filling out some information with a brokerage and letting them handle the paperwork. You can set one up manually via the IRS, as well. It’s all quick to get the account set up and running.

Easy to Set Up and Manage

Additionally, managing a SEP-IRA is simple through most firms. Usually, they’ll have a selection of pre-packaged and managed investments you can buy into, shuffle funds between, and watch grow. These portfolios are balanced according to target retirement ranges or other goals and include a variety of assets, stocks, and other investments. Since it’s all managed behind the scenes by the brokerage, you don’t have to fiddle with individual purchases or watch the markets yourself.

3. Variable Contributions

Another benefit of the SEP-IRA is that you don’t have to set a contribution rate and stick to it as you do with other forms of retirement. You can contribute a maximum of 25% of your compensation one year, but if the next year is leaner, you can choose to contribute less or even nothing at all.

Variable Contributions

The requirement to contribute the same you do for your employees can make this an ethical dilemma as a business owner, but there’s no legal requirement to contribute the maximum you can.

4. Contributions Are Tax-Deductible

Like a traditional IRA, the SEP-IRA contributions are tax-deductible as a business expense. This deduction includes your contributions and the contributions you make to your employee accounts – it can amount to a reasonably significant business expense write-off in the right situations.

SEP-IRA Contributions and Deductions

Of course, if you’re self-employed or have zero employees, this isn’t meaningful compared to a traditional IRA. A small business with a small handful of employees can see quite a bit of benefit from the tax implications of those deductions.

5. Non-Exclusive with Other IRAs

There are no rules against having other kinds of IRA alongside a SEP-IRA. You can still maintain and contribute to a traditional or ROTH IRA. The only potential issues are traditional IRAs’ contribution limits and their deductions, which can get a little tricky at higher income levels.

Non-Exclusive With Other IRAs

Suppose that all of this sounds good to you – great! A SEP-IRA might be an excellent choice for your investment. However, there are a few downsides to the SEP-IRA format, which you should know before diving in.

What Are the Downsides of a SEP-IRA?

Many of the drawbacks of a SEP-IRA come down to it being a traditional IRA, though a few are specific to the SEP format.

1. All-Or-Nothing Employee Inclusion

First of all, if you’re a small business with a handful of employees and set up a SEP-IRA, you must set up accounts for eligible employees.

All Or Nothing Employee Inclusion

As a reminder, any employee who meets these requirements is eligible for inclusion in the SEP-IRA:

  • Employees that are over the age of 21 are eligible.
  • Employees that have worked for you for three of the last five years are eligible.
  • Employees who have been paid over $600 in a year are eligible.

You cannot pick and choose to give only management, or only vested employees, access to the SEP-IRA. Your only other option is not to use a SEP-IRA at all.

2. Matched Contributions

Whatever percentage of your compensation you contribute to your SEP-IRA, you have to contribute equally to your employee’s accounts. You might be able to swing 20% of your income into contributions, but adding in 20% of each of your employees’ salaries can be more significant. While the all-or-nothing regulation doesn’t seem devastating, it becomes harsh when adding the matched contribution percentage described above.

Matched Contributions

Of course, since the contributions are tax-deductible, this isn’t as much of a burden as you might expect it to be. Generally, higher contributions are more beneficial, save for a few rare circumstances.

3. SEP-IRAs Lack Catch-Up Limits

With a standard IRA account, you have annual contribution limits of about $6,000. However, suppose you’re over the age of 50. In that case, that limit is increased to $7,000 for older people to save more for their impending retirement, to better take advantage of interest compounding in whatever short amount of time they have before retirement rolls around.

Catch Up Limits

SEP-IRAs do not have this catch-up shift in contribution limits. Your limits are the same at age 21 as at age 65. With the much higher base contribution limits, this is rarely an issue; however, it’s still noteworthy for some older investors.

4. No Added Benefit for Employees

With a standard 401(k) retirement plan, one of the benefits to the employee is that they contribute from their paycheck, and their employer matches the contribution (up to a certain point, anyway). Feeding into the account from two directions gives the employee much more money to invest and build.

SEP-IRA vs 401k

With a SEP-IRA, 100% of the money contributed to the account comes from the employer. The employee cannot add more funds to the account to further invest; they will have to find other forms of retirement savings to put their own money into.

Additionally, this places the burden of funding the account on the employer. You end up with many decisions to make regarding how much you contribute.

5. Early Disbursement Penalties

Investments typically come in three forms.

  • Accounts you can freely add or remove money from at any time.
  • Accounts you can withdraw money from at any time but may pay the penalty if you’re too young (under 59 ½ years old.)
  • Accounts you cannot remove money from unless you demonstrate financial hardship.

SEP-IRA accounts fall into the second category. There are, generally, penalties if a younger individual tries to remove money from their SEP-IRA account. However, money may still be able to be rolled over to other IRAs. Additionally, individuals may qualify for certain exemptions from the penalty, depending on various factors specified by the IRS.

Early Disbursement Penalties

Additionally, you cannot take out a loan of your SEP-IRA funds in an emergency. A penalized withdrawal is the only option.

6. Deferred Taxes

Traditional IRAs and SEP-IRAs share the same tax implications. You can deduct contributions from your taxes when you contribute but pay taxes on the money you receive as a disbursement in retirement.

Tax Deferred Savings

Deferred taxes can be a benefit or a drawback, depending on how you expect your income to scale. The decision between a traditional and a ROTH IRA is all about timing, tax brackets, and anticipated revenue. It can be challenging to decide, considering how few of us can plan even a few years, let alone decades.

Is a SEP-IRA Worth It?

Generally, yes, a SEP-IRA is a powerful investment tool for individual freelancers and small business owners. The larger your business grows, and the more employees you have, the less valuable a SEP-IRA plan is to you. However, should you plan to remain a sole proprietor or a freelancer, a SEP-IRA can be a great way to invest a significant amount of money in a relatively short amount of time to build up compounding interest.

Is a SEP-IRA Worth It

Additionally, many businesses can benefit significantly from the tax deduction involved in contributing to their and their employees’ SEP-IRA accounts. Talking to a financial advisor about your specific situation is ideal, but a SEP-IRA is an excellent choice in many cases.

Often, the decision will come down to choosing between a SEP-IRA and some form of 401(k). In this case, the decision is more complex; 401(k)s have higher contribution limits as well, but dual contributions have the potential to be more valuable. Again, consider speaking with a financial advisor about your specific situation to help you make an informed decision.

Are you considering a SEP-IRA for your retirement account? Do you have any employees, and how does this affect your decision? Do you have any questions for us about opening a SEP-IRA? Please share with us in the comments section below, and I’ll do my best to point you in the right direction!

Next Article

Poor Man’s Covered Call [The Ultimate Beginner’s Guide]

Posted on by Chris Butler

Last updated on May 6th, 2022 , 03:48 am

Poor Man's Covered Calls featured image

One of the great benefits of options trading is the strategy customization available to traders.

In this post, you’ll learn a strategy that aims to reduce the margin requirement/maximum loss potential of the covered call options strategy.

What is a Poor Man's Covered Call?

The poor man’s covered call (PMCC) is a bullish options strategy that is an alternative to the covered call strategy requiring significantly less capital to trade.

The PMCC strategy reduces the capital/margin requirement of a traditional covered call by replacing the long stock with an in-the-money call option purchase in a long-term expiration cycle.

A traditional covered call requires significantly more capital than a poor man's covered call.

In a traditional covered call, an investor:

  • Buys 100 shares of stock

  • Shorts/writes an out-of-the-money (OTM) call option against the shares.

But buying 100 shares of stock requires significant investment.

In a PMCC, the 100 shares of long stock are replaced with an in-the-money long call in a longer-term expiration cycle than the short call.

Buying an in-the-money call option requires less capital than buying 100 shares of stock, reducing the margin requirement and maximum loss potential of the strategy.

A poor man's covered call is created by replacing a traditional covered call's 100 shares of stock with an ITM call option.

The poor man’s covered call strategy allows options traders to gain similar exposure to a covered call at a fraction of the cost of a traditional covered call position.

The PMCC is technically a “diagonal debit spread,” which is a call spread with options in two different expirations instead of one expiration (which is the case for a vertical spread).

How to Set Up a Poor Man's Covered Call (Example)

To set up a poor man’s covered call, a trader will:

  • Buy a deep in-the-money call option in a long-term expiration cycle (90+ days to expiration or DTE as a guideline).

  • Short an out-of-the-money call option in a near-term expiration cycle (fewer DTE than the long call).

How to set up a poor man's covered call: buy an ITM long-term call, short an OTM short-term call.

Let’s create a real PMCC using AAPL options.

Setting Up a PMCC in AAPL

As of this writing, the current price of AAPL is $164.

To set up a PMCC, a trader could:

1) Buy the 140 call option in the July 2022 expiration cycle (118 DTE), paying $27.65 for the option (capital outflow of $2,765).

Buy the July 140 Call (118 DTE) in AAPL (Share Price = $164)

2) Short the 175 call option in the May 2022 expiration cycle (62 DTE), receiving $3.10 for the option (capital inflow of $310).

Shorting an OTM call in AAPL
Short the May 175 Call (62 DTE) in AAPL (Share Price = $164)

Poor Man’s CC Trade Cost => $2,455 ($2,765 outflow – $310 inflow).

PMCC Trade Cost = Cost of Long Call - Credit from Short Call

If we constructed a normal covered call, we’d need to buy 100 shares of AAPL at $164 (paying $16,400 if no margin is used) instead of buying the July 2022 call.

Traditional CC Trade Cost => $16,090 ($16,400 outflow – $310 inflow).

The significantly lower capital requirement relative to a normal CC is where the poor man’s covered call gets its name.

The above images were taken on tastyworks, our preferred options trading brokerage.

Max Profit Potential

The “simple” maximum profit calculation of a poor man’s covered call is the same formula as a bull call spread’s max profit:

Max Profit: Width of Call Strikes – Trade Cost

 
Here are the trade details from our AAPL example above:
The "max" profit of a poor man's covered call is the width of the call strikes minus the trade cost.

In an exaggerated scenario, if AAPL shot up to $300/share shortly after trade entry, both calls would be deep ITM and would consist mostly of intrinsic value.

The 140 call would have $160 of intrinsic value and the short 175 call would have $125 of intrinsic value. The position’s price would be $35 if both options had no extrinsic value, and the trade’s profit would be $10.45 (trade price increases to $35 from a trade cost of $24.55).

But because the strategy consists of two options with varying expiration dates, the true maximum profit potential depends on how the position is managed.

In a PMCC, the short call expires sooner than the long call. If the PMCC trader allowed the short call to expire OTM and continued holding the long call, they would be left holding a naked long call and therefore have unlimited profit potential.

Max Loss Potential

The maximum loss potential of a poor man’s covered call is the cost to enter the trade.

In the above AAPL example, the total trade cost was $24.55 (a capital outlay of $2,455).

Therefore, the maximum loss of that position would be $2,455.

Max loss of a poor man's covered call = trade cost

If AAPL’s share price remained below the call strikes of 140 and 175 through both expiry dates, both options would expire worthless and the trader would experience the following profits and losses on each leg of the trade:

  • Profit of $310 on the short 175 call

  • Loss of $2,765 on the long 140 call

Total Loss => $2,455 (initial trade cost)

Implied Volatility vs. Poor Man's Covered Calls

What’s the ideal change in implied volatility (IV) when trading PMCCs?

The visual below describes the favorable changes in IV when trading PMCCs:

Implied Volatility vs. Poor Man's Covered Calls. If the stock rises to the short call strike, the position will be negative vega and you want IV to fall. If the stock falls to the long call's strike, the position will be positive vega and you want IV to increase.

If the underlying stock price moves to or above the short call’s strike price, you want IV to fall.

Why? A decrease in IV is synonymous with a decrease in extrinsic value.

If the stock price rises to the short call strike, the long call will have mostly intrinsic value and little extrinsic value.

A decrease in IV will increase the trade’s profits driven by a drop in the short call’s value that exceeds a minuscule (or no) drop in the long call’s value, as intrinsic value is immune to changes in IV.

If the underlying stock price moves to or below the long call’s strike price, you want IV to increase.

Why? An increase in IV is synonymous with an increase in extrinsic value.

If the stock price falls to the long call strike, the long call and short call will be 100% extrinsic value.

An increase in IV will increase the trade’s price (reducing your loss) driven by an increase in the long call’s value that exceeds the increase in the short call’s value.

Time Decay vs. Poor Man's Covered Calls

Is time decay good or bad for poor man’s covered call positions?

The visual below describes how the position’s theta will change depending on where the stock price is relative to the call strikes:

Time Decay vs. Poor Man's Covered Calls. If the stock rises to/above the short call strike, the position will have positive theta and profit from the passage of time. If the stock falls to the long call's strike, the position will have negative theta and lose money from the passage of time.

If the stock price declines to the long call strike, the passage of time will drive losses in the trade (the position will have negative theta).

In this situation, both calls in the trade will consist of mostly or all extrinsic value.

The long call will be notably more valuable than the short call, meaning the long call will lose more value than the short call as time passes (negative theta).

If the stock price increases to the short call strike, the passage of time will drive profits in the trade (the position will have positive theta).

In this situation, the long call will have mostly intrinsic value and little extrinsic value, while the short call will have mostly (or all) extrinsic value.

Since intrinsic value does not decay, owning a deep ITM call with little extrinsic value and having a short ATM/OTM call with purely extrinsic value results in positive theta (profits from time passing).

How to Choose Strike Prices

Selecting strike prices can be an overwhelming process for beginner traders because there are so many options to choose from on the options chain.

Here are some rough guidelines that will help you choose call strikes for your PMCC trades:

1) Buy a call with a delta over 0.75 (a “deep” ITM call) with 90+ DTE.

2) Short a call with a delta below 0.35 (an OTM call) with <60 DTE.

Again, these are rough guidelines that can be adjusted in your specific trades. Don’t interpret the above guidelines as hard rules.

Here’s a visual representation of the target strike prices and days to expiration:

Poor Man's Covered Call Strike Price Guidelines: Buy a 0.75+ delta call with 90+ DTE and short a

Let’s talk about why these guidelines are helpful.

Guideline #1: Buying a Deep ITM Call With 90+ DTE

Buying a deep ITM call results in owning an option with lots of intrinsic value and little extrinsic value.

Options lose extrinsic value as time passes, which is referred to as “time decay.” Intrinsic value does not decay.

As the owner of the option, we don’t want the option to lose value over time, which means buying an option with mostly intrinsic value won’t experience much time decay.

Compared to an at-the-money (ATM) or OTM call, an ITM call will have a lower theta value, indicating a lower amount of time decay with each passing day.

Longer-term options also have lower theta values than shorter-term options, further protecting us from time decay.

Lastly, by purchasing a call with a delta of 0.75 or higher, the call’s price will change similarly to owning 100 shares, helping us replicate a covered call without an actual long stock position.

Guideline #2: Short an OTM Call With <60 DTE

Shorting an OTM call results in betting against an option with 100% extrinsic value.

Short option traders profit when the option value falls, benefiting from time decay.

An OTM option’s price will fall to zero if it is still OTM at its expiration date.

Shorter-term options decay faster than longer-term options, which is why a shorter-term expiration cycle is used for the short option in a PMCC position.

A call with a delta of <0.35 will have a strike price decently higher than the share price, allowing for more upside profit potential compared to shorting a call that’s closer to the stock price.

Be Careful of the Entry Cost

It is essential that the entry cost is notably less than the width of the strikes.

Otherwise, the position’s max profit potential will be minuscule (or negative).

tastytrade’s guideline is that the trade cost is less than 75% of the width of the strikes. I agree with this guideline.

In our earlier AAPL example, the width of the strikes was $35 and the trade cost was $24.55 (70% the width of the strikes).

The guideline is important because, should the stock price surge, the position’s price will trend towards the width of the strikes.

Because we are trading two options in different expiration cycles, it’s possible to pay more than the width of the strikes:

Bad PMCC setup. Trade Cost > Strike Width
In the image above, the strike width is $15 and the trade entry cost is $15.22.
 
As a theoretical example, if the stock price shot up to $1,000, the position’s price would end up at $15.00 because the options would be so deep ITM that they’d have almost no extrinsic value.
 
If we paid $1,522 for a position that ended up being worth $1,500 when the stock price surged, we’d lose $22 on a trade we entered to profit from stock price rallies.
 
Listen to tastytrade’s guideline and avoid this situation by only entering positions that cost less than 75% the width of the strikes.

How to Manage a Poor Man's Covered Call

If the short call remains OTM as time passes/expiration nears, the trader can buy back the call for a profit and short a new call in the next expiration cycle to collect more premium and continue the strategy.

Eventually, the trader will need to close/roll the ITM call once it gets close to expiration, but the longer-term call won’t need to be managed as frequently as the shorter-term short calls.

If the stock price surges and both calls are ITM, the trader needs to decide if they want to continue the strategy.

In the case of the stock price being above the short call’s strike, the passage of time will continue to drive profits in the trade.

Once the short call’s extrinsic value drops close to zero, the position will be at its maximum profit potential with the current setup. The trader can then close the entire trade.

How to Close a Poor Man's Covered Call

To close a PMCC position, buy back (cover) the short call and sell the long call. Sell what you own and buy what you’re short.

In our previous example of entering a PMCC in AAPL by purchasing the JUL 140 call and shorting the MAY 175 call, a trader can close the position by:

  • Selling the long JUL 140 call

  • Buying/covering the short MAY 175 call

You can complete these transactions with one order.

If you decide to “unwind” the position with separate orders, start by buying back the short call, then sell the long call.

Early Assignment Risk When Trading PMCCs

Is there early assignment risk when trading PMCCs?

Yes, because there is a short option component in the position.

If the stock price moves above the short call’s strike price, the trader may get assigned short stock if a counterparty trader exercises the call option.

But don’t worry! Assignment risk is low unless the short call is ITM with close to zero extrinsic value, which happens when:

  • The short call option has little time to expiration, and/or:

  • The short call option is deep ITM.

The further ITM a call option is, the less extrinsic value it will have.

The less time to expiration an option has, the less extrinsic value it will have.

So if you’re trading a PMCC and the short call is ITM with multiple dollars of extrinsic value, you do not need to worry about early assignment risk.

The only other thing to watch out for is if the stock has an upcoming dividend payment. In that situation, any ITM short calls with extrinsic value less than the amount of the dividend are at risk of early assignment.

Tax Implications When Trading PMCCs

There are tax considerations that options traders need to be mindful of when trading poor man’s covered calls.

In a traditional covered call, the trader will own 100 shares of stock, which have no expiration date and can be held forever. Once the shares are held for more than one year, any gains on the shares will be taxed at the long-term capital gains rate.

In a poor man’s covered call, the trader uses an ITM call option instead of stock, forcing the trader to sell/roll the long call once it reaches expiration.

If the trader bought a call with 120 DTE, they would need to sell the call before expiration and buy a new ITM call to continue the trading strategy.

Consequently, any gains on the initial call would be taxed at the trader’s short-term capital gains rate because they held the option for less than one year.

Conclusion

The poor man’s covered call is becoming a popular options strategy for those with limited capital.

The strategy significantly reduces the capital requirement (and max loss) of a traditional covered call by replacing long stock with a deep ITM call option. The lower buying power requirement also boosts the potential return on capital.

However, it is much easier to lose 100% of your investment with a PMCC compared to a traditional CC, making it a more aggressively bullish strategy.

Compared to a traditional covered call, a PMCC will require more active management as the strategy is composed purely of options contracts.

There are also greater tax implications when trading PMCCs because each trade component will typically be held for less than one year, pushing all gains into short-term capital gains taxation.

But for those interested in gaining exposure to covered calls with less money, the poor man’s covered call is an option (pun intended).

*Before trading options, traders should read the Characteristics and Risks of Standardized Options, or the Options Disclosure Document (ODD).*

Back to All Strategies ➥

Next Lesson

Chris Butler portrait