I was wondering what you thought of Steve Smith article at
Minyanville basically blasting covered calls and recommending instead, combining the
following two techniques:
"Replace the underlying long stock with
the purchase of an in-the-money LEAP, or long-term call option.
Rather then selling a single strike call, sell a vertical spread
for a credit."
After reading your book on Creating Your own Hedge Fund. I certainly will be
sticking with your recommendation. Nothing like getting an instant discount when buying stock,
especially when I have no ambitions to sell the ETF once purchased. Looking
forward to studying it more in depth and just ordered your other book on Options
for Rookies, hope to enjoy it equally as well.
1) You will like the new book much more than you did Create…
I'm pleased you like the covered call strategy, especially after living
through the 2008 market debacle. In the Rookie's Guide (and throughout
this blog) you will find other strategies that are similar. The
advantage to any of those alternatives is reduced risk. Yes, that
comes with reduced reward potential, but that's where you get to decide
which is 'better' for you.
If you like the idea of being invested in
the markets, writing covered calls will suit you nicely. If you prefer
more protection – call it insurance – you may prefer collars, or it's
equivalent, selling OTM put spreads.
The strategy you asked about is worth considering. I'm
NOT telling you that it's better because that is such a relative term and better for me is not necessarily better for you. There are advantages – especially
when you are very bullish, but there are disadvantages, such as less protection in a down market.
3) I agree with Smith that writing covered calls leaves much to be desired in the risk department.
But for investors (as opposed to traders looking for short-term profits) who plan to remain 'long the market' all the time, I believe writing covered calls is a viable method.
Because I believe so strongly in the importance of risk management to long-term success as a trader, Steve's idea is very much worth discussing.
4) The term is LEAPS, not LEAP or 'leaps.' And Steve should know better.
5) Some people who discuss option strategies recommend replacing stock with LEAPS and selling calls against those LEAPS. They look at the position as being a modified covered call, but technically it's a diagonal call spread.
That modification to writing covered calls has merit, but I don't recommend it. For the sake of being thorough, let's look at that idea before moving on to Steve's suggested strategy.
Both the good news and the bad news with owning LEAPS, instead of stock, is that they are options with less than 100 delta.
If the stock tumbles, it's far better to own one LEAPS option than 100 shares of stock. First, LEAPS cost less than stock and the maximum loss that results from a severe decline in the stock price is significantly reduced. In addition, such a price decline is often accompanied by an increase in implied volatility. The owner of a LEAPS call benefits from that IV increase because LEAPS are vega-rich. Thus, the LEAPS option will be trading at a higher price than you might expect when the stock tumbles – and that results in a further reduction of losses. That's all good.
But, if the stock rises sufficiently and your short option moves significantly ITM, the LEAPS option now increases in value at a SLOWER rate than your short option – because it still has less than 100 delta. Whereas a covered call never runs into trouble on the upside, that's not true for the owner of a 'LEAPS covered call' position.
Bottom line – using the LEAPS has a lot to recommend it, but it's not foolproof.
6) The strategy discussed in the Minyanville post is different. Significantly different. It has it's good points and bad points, but it is a trade I not only like, but frequently use in my own trading and discussed previously on this blog (although it's in disguise and may not be readily recognizable as the same method).
It's worth looking at this idea in detail. To make it easier to follow, I'll include charts – per the suggestion from Simon.