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:
MARGIN AND OTHER BORROWING
Q. Should the average investor consider buying stocks on margin for covered call writing?
A. In my investment books I talk a lot about risk and the varying degrees of risk one takes in writing covered calls (less risk than simply owning stocks or ETFs) and the progressively greater risk taken when using other option strategies, culminating with the greatest risk assumed when writing uncovered combinations. An additional element of risk is assumed when using margin or other debt to finance investments. With respect to covered call writing, you would use margin to acquire up to twice the number of shares you would be able to buy with your own funds. This, in turn, permits you to write twice as many call contracts. The effect is that you double your investment return potential (less the percentage rate you pay on the margin borrowings). For that opportunity you double your potential for loss on the underlying shares. If the share price remains flat or increases, your option premium income is doubled and, if you wrote out-of-the-money calls, the capital gain opportunity on the shares is also doubled. If the share price falls, you have lost twice as much on the shares while paying interest on the borrowed amount for the privilege. At least the premium income from the contracts written on the additional shares would offset some of the loss on the additional shares. Think of it this way: if you absolutely knew that the market wasn't going to go down (meaning it would either stay flat or go up by any amount), how much would you borrow to buy additional shares. The answer is that you would borrow as much as you could from any source, because if the market on your shares didn't go down you would get twice the premium income from your covered call writing for a fairly small charge of interest expense. Unfortunately we have no such guarantees. But if you are mentally prepared to take more risk and during a time in which you are absolutely convinced that the market will at least stay flat but not go down, that's the time to use margin to buy additional shares and write covered calls on them.
Q. Who should consider borrowing money to invest in the market or for uncovered put or combination writing?
A. The gist of this question implies not just borrowing from the broker on margin (say, for covered call writing) but borrowing through other sources for investment. Only those investors who have plenty of resources and can stand large losses should consider such a strategy. Moreover, even investors with substantial resources may find that they cannot cope with taking such additional risk. If you find yourself worrying excessively or not able to sleep, that is a sure sign that you are taking too much risk either from the money you have borrowed and/or the riskiness of the securities you are selecting. Back off until your comfort level is reached.
Q. By borrowing money and using your option writing programs I hope to generate a regular cash flow for retirement, as I haven't been able to save much. I have a lot of borrowing power. How do I know how much money I should borrow given the risks involved?
A. There is no way to answer that question definitively, as every person has a risk tolerance that is unique to them. You will have to experiment and find it out for yourself. Assuming you are going to borrow to invest in stocks or ETFs, the least risky strategy would be to use margin to acquire additional shares and to then write covered calls on all of the shares. The most risky would be to borrow money from anyone other than your broker, put the money in your brokerage account and then use the funds provide the margin to write uncovered put and call combinations. There is ample risk in the combination strategy without using borrowed funds. Having said that, no doubt there are people who can withstand the stress of that kind of risk to leverage the return opportunity to over 1,000%. The best solution, I believe, for those who wish to experiment with using borrowed funds is to practice option writing transactions "as if" you were using borrowed money to see what kind of results you can generate. By tracking your results you will discover soon enough whether you would be experiencing success or disaster. Even if you find you have the success and temperament from just practicing, that will not ensure success when you are using real borrowed money. Therefore, the word to the wise is "go slowly." If you insist on borrowing money for investment, use small amounts of borrowed funds at the start and stick with conservative stocks/ETFs. Only time will tell whether you can succeed at this. If you are losing sleep or are spending your days worrying, that's a sure sign that you are overextended with borrowing and/or are taking too much risk in your investment strategy. Back off until you quit worrying and can sleep. With the strategies outlined in my options books you can get excellent returns without taking the additional risk by borrowing money. Not many investors have the temperament to leverage themselves heavily and still lead normal lives!
