Mr. Kadavy has answered the following questions from readers that may be helpful to others. If you have a question, please use the "E-mail Me" button above. Answers will be provided by return e-mail and, if applicable to a broad cross-section of readers, will be posted to this page:
COVERED CALL WRITING
Q. When should an investor write in-the-money calls?
A. The only time you should write in-the-money calls is if you believe the price of the underlying stock that you own is going to decline by the expiration date below the strike price you have selected. You will receive a very large premium for writing in-the-money calls, because part of the premium consists of "intrinsic" value (the amount by which the share price exceeds the strike price) and part of it is "time value" (note: in an at-the-money or out-of-the-money call, all of the premium you receive initially is time value). Thus, if the share price goes down below the strike price you will keep all of the option premium and will have hedged the decline in price by the amount of the premium. The risk you face by writing in-the-money calls is that the share price does not decline and that your shares are called away from you on the expiration date of the calls at a price that is not attractive to you.
Q. I have a number of covered calls, some of which currently exceed (and others about to exceed) my strike prices...all originally set 5 -12% over market. In your book you indicate it is almost never advisable to buy-to-close a position. Under what circumstances would you recommend a buy-to-close?
A. I try to maintain simplicity in my books for most investors and yet provide an opportunity for double-digit returns, so for that primary reason I generally don't recommend that most covered call writers buy back their positions. It also obviously generates more commissions. There's certainly nothing wrong with doing that if you are a savvy trader and it makes economic sense. For example, if an option can fairly quickly be bought back at a small price and a new position established that makes sense to you (e.g., rolling down when the market declines), then you may want do do it. In most cases I don't believe in buying back the option at a loss, unless you want to keep the stock under all circumstances. If that was the case, then a call probably shouldn't have been written on it in the first place.
Q. Closed-end funds such as ETW and BOE claim to use a covered call strategy to produce income. Your comments would be appreciated.
A. I know that there are a number of funds out there that use a covered call writing strategy, but I'm not familiar with these two. They obviously charge a fee for investment management, so if investors want to employ a covered call writing but don't want to do it on their own then a fund with a good track record may be a reasonable way to go. It seems to me that with all of the ETF alternatives out there it should be reasonably easy for just about any investor to get good diversification from one or more ETF portfolios and then do your own covered call writing or put writing. Frictional costs for investment management can add up to a lot over time. That's why I wrote my books...to give people a turnkey method of doing it themselves and through online discount brokers to eliminate as much frictional cost as possible.
Q. Is the "Ratio Bull Spread" a good strategy for conservative investor ? Would this play suitable for this investment climate ?
A. Option strategies such as the one you mention can get very complicated. I have never had any interest in strategies that incorporate both the simultaneous selling (writing) and the buying of options. I like getting the stream of income from option selling and don't like the cost of buying options, so all of the strategies I use and write about in my books incorporate only option selling and not buying. I want the decaying value of the option time component to work in my favor, not against me. I also believe in keeping things very simple, both for myself and for the people who read my books. That's not to say that the use of other strategies may not be right for you if you fully understand what you are doing, are a sophisticated investor and the risk associated with the strategy is consistent with your risk appetite. It would be impossible for me to say if what you are suggesting is a good strategy for a conservative investor. That obviously depends on what the market is going to do, and I don't pretend to have a clue about that. That's why I like the downwide protection offered both by writing calls and puts. The Ratio Bull Spread is a limited bullish bet up to a certain price where you believe resistance will occur. You won't get much net income from the spread, and perhaps would have a net outlay, depending on what you buy and what you write. To make this work effectively you need to know what direction the underlying security is headed and how far it will go relative to other investment opportunities. Since most active professional investment managers can't outperform the S&P 500 over time, I wouldn't presume to know that much about any given security. That's why I like keeping it simple and writing uncovered puts, covered calls or short Spider straddles based on my overall feeling about where the market may be headed, recognizing that it's usually impossible to even know that much. The option writing income provides the overall return and also some limited downside protection I'm seeking and I don't have to do much guessing about the rest of it.