When we buy one share of the Qs (Powershares Exchange-Traded Fund Trust – Powershares Qqq Trust, (NASDAQ:QQQQ) for $45, we are purchasing a piece of all 100 shares in the fund. So how does that work? Are we applying $0.50 towards each stock? It’s actually a bit more complicated than that.
The Qs are an exchange-traded fund (ETF). Let’s define:
This is a security that tracks an index, a commodity, or a basket of assets like an index fund, but trades like a stock on an exchange, thus experiencing price changes throughout the day as it is bought and sold. These securities provide the diversification of an index fund. Using ETFs for covered call writing is a great way to get started for those extremely conservative, those who stress capital preservation with lower risk and reward and for those with small amounts of capital to invest. These benfits are a result of the instant diversification achieved with an ETF and the lower implied volatility associated with a basket of stocks as opposed to a single equity.
The Mechanics of an ETF:
These funds are continuously creating new shares or redeeming existing shares depending on market demand. The shares represent ownership interest in the underlying basket of securities. Only large institutional investors called Authorized Participants (APs) partake in this creation and redemption process. They will buy creation units or sell redemption units over sophisticated electronic platforms. Shares are created when the APs provide a basket of securities to the fund which then creates ETF shares that are handed over to the AP. These ETF shares are then sold on the secondary market (exchanges) to us by the APs.
On the other hand, when an AP provides the fund with a number of ETF shares (redemption unit), they will receive from the fund the associated basket of securities.
What’s in it for the APs?:
Are they doing this to be nice guys and allow BCIs to take advatage of these funds? I don’t think so either! They are doing it to take advantage of arbitrage opportunities. These are simultaneous purchases and sales of assets in order to profit from a difference in the prices. Here’s how the game is played:
The underlying securities in an ETF are priced every 15 seconds during the trading day. This value is similar to the NAV (net asset value) of a mutual fund which is priced only after market close. When there is a small difference between the intraday NAV and the actual share price of the fund, the AP can buy one and sell the other to generate a profit. This arbitrage process actually serves a useful function for us in that it keeps the fund price and the NAV price very close.
ETF Pros:
· Diversification
· Lower annual taxable distributions
· Lower costs
· Lower management fees
· No 12-b-1 fees (marketing and distribution costs)
· Trading flexibility
· can be purchased on margin
· can be bought and sold @ intraday market prices
· can be traded with stop and limit orders
· can be sold short
ETF Cons:
· subject to market risk like investor sentiment and global conditions
· market pricing discepencies (between NAV and actual share value) particularly in less liquid funds
· tracking discepencies- returns may be more or less than the benchmark for the follwoing reasons:
· a fund may sample the benchmark rather than duplicate it exactly
· dividend distributions from a fund may differ from the equities themselves
· the expense ratio reduces profits
· regulations require no one company represent more than 25% of the fund. This may not represent the actual fund allocation.
ETFs and covered call writing:
The conservative approach would be to get the most diversification so that out-of-favor securities can be picked up by the others. Usually, the greater the diversification, the lower the premiums, due to the lessened volatility. But this seems to suit the needs of conservative investors.
Two popular ETFs with tremendous diversification are:
VTI- Total Stock Market
SPY- S&P 500
For greater premiums but also greater volatility:
QQQQ- Nasdaq 100
IWM- Small Cap
Other popular ETFs:
DIA- Dow 30
MDY- Mid-Cap 400
I have been using the Qs in my mother’s account for years with excellent success. For the most conservative approach, look @ VTI and SPX and expect a return of 1-2% per month in normal market conditions.
Conclusion:
ETFs are vehicles that can benefit both institutional and retail investors. For writers of covered calls, the main asset is its instant diversifiction that permits a conservative approach to an already conservative strategy.
Where’s Alan??????????
I will be out of the country this week with limited email access. I’ll try to answer some emails and post on the blog and catch up after I return. All books will be shipped in the timely manner you are used to however, DVDs, CDs and Companion Workbooks will be shipped on February 1st. Blog articles have been written in advance and will be published weekly.
Last Week’s Economic News:
The market took a major hit this week as President Obama announced new regulations on the banking industry. Other signals were mixed:
· jobless claims (nonfarm payrolls) were up
· new housing starts fell 4% when an increase was anticipated by analysts
· producer prices rose due to inflation in food and energy products
· the Conference Board’s index of leading economic indicators was up for the ninth consecutive month
For the week, the S&P 500 was down 3.9% for a year-to-date return of -2.0%.
Next Week’s Economic Reports:
· Monday: exisiting home sales
· Tuesday: consumer confidence
· Wednesday: Fed decision on short-term interest rate, new home sales
· Thursday: durable goods
· Friday: 4th quarter GDP report, unemployment cost index
_____________________________________________________________________________________
Video playing on the homepage:
The Philosophy of the Blue Collar Investor
Your support will never be taken for granted.
My best,
Alan
30 responses so far ↓
1 admin // Jan 23, 2010 at 6:38 am
Reminder:
I will be out of the country through January 31st. I will do my best to check in from time to time to respond to emails and posts and intend to catch up the first week of February.
The first week of this 5-week contract cycle has been a rough one with president Obama’s announcement of new banking regulations and a few negative economic reports. The good news is that we have a full 4 weeks remaining until contract expiration, plenty of time for our equities to recover and perhaps some extra cash from exit strategy maneuvers. Of course, we also must be prepared to act should the market continue to tumble.
Let’s keep an eye of the VIX which has been up of late. A stabilizing or relaxing of this index will bode well for recovery.
Alan
2 Amy // Jan 24, 2010 at 5:32 am
Alan,
Excellent video on the homepage. I’ve been sending it to friends who don’t quite understand what covered calls is all about. Keep up the good work.
Amy
3 Duane Heidel // Jan 24, 2010 at 8:28 am
Alan, you and Linda have a great/safe trip and smell the roses!!! The markets will be here when you return.
Best regards,
Duane
4 Don B // Jan 25, 2010 at 3:15 pm
All:
I am reminded of being back in school when the teacher had to leave for a minute saying “discuss it amongst yourselves, until I return.”
SO – looking at QQQQ after the close today, Monday, it is at 44.31. Without looking at the other technicals, and observing that the Feb 44 bids at 1.24 while the 45 bids at .70c, I am considering a new buy/write. Which may be the best choice? The 45 is .70/44.31 or .015%. If assigned, one adds the price improvement of .69. So would total .70 + .69 /44.31 or 3.13%. The 40 ITM would net 1.24 -.31 if called, or .93/44.31 or 2.09%.
Which would you choose? Anyone? Thanx.
Don B
5 Dave D // Jan 26, 2010 at 2:02 am
Hi Don…
Personally I would choose the 44 (ITM) strike price for the following reasons…
1) The technical indicators are all bearish, hence, some downside protection is much prefered.
2) The market in general has been a “little” bearish recently.
3) With the ITM your still getting a ROO of 2.1% (at the 44 strike)…
4) You’l get a little downside protection. (31c)..
Keep in mind that the 45 strike could be more profitable if the stock goes up… The thing I do like about the ITM strike is the stock can go down a little and you still make money…
Happy Trading Don!
Dave
2)
6 admin // Jan 26, 2010 at 7:03 am
Hi to all,
Linda and I are having a terrific cruise through the Carribean. May be taking the covered call system too far….the other night in the casino I bought 100 $5 chips and offered to sell it back to the dealer for $10 in the next 2 hours.
They now have wireless remote in the cabins but a bit pricey. After the 1st 15 minutes they actually take your first born……..
Hope you’re all doing well. Lots of exciting things happening this year…will keep you posted. Thanks for all the kind emails. Will catch up next week.
Our very best,
Alan and Linda
7 Dave D // Jan 26, 2010 at 10:37 pm
JOYG
In the last week or so this stock has taken a dive! Im not sure why as its been more bearish than most stocks recently…
Does anyone know whats going on with JOYG?
I originally rolled down with JOYG, but now am probably going to ‘convert dead money into profits’…
Any news on JOYG is welcome…
Dave D
8 GaryM // Jan 27, 2010 at 5:26 am
Dave D,
JOYG in my opinion is in a sector that is sensitive to commodity prices-oil, copper, iron ore and the commodities are getting ripped right now. It will recover.
9 Eric R. // Jan 27, 2010 at 8:22 am
All –
This is a neat little trade I just did that I wanted to share. I bought PXP at 31.64 and sold the 31 Feb call for 2.20 on 1/13/2010. This gives me $156 in time value or 156/3100 = 5.0% return for 6 weeks. Today PXP rocketed up huge and I notice my call is now trading for 4.80, but the stock is trading at 35.60. This is only .20 of time value that I felt was a waste if I just let it sit for the next 3 and ½ weeks to expire. So here is what I did. I bought back my option for 4.80 and sold the 36 Feb call for .99. Yes, Rolling up in the same contract month. So the calculations look like this.
(4.80 – .99) * 100 = ($381). But I bought up my stock so I have to add back in the $460 (35.60 – 31.00) * 100. I also have more upside potential now . 40 * 100 = $40. So if I add all this together I get:
460 + 40 -381 + 220 from original option = 339 / 3100 = 10.9% return!!
(Alan – please let me know if I goofed up my calculations at all… thanks!)
Happy trading to all
Eric
10 admin // Jan 27, 2010 at 9:52 am
Eric,
EXCELLENT!!!!!!!!!!!
I hope a lot of our readers get to read your post as it demonstrates how a sophisticated level of knowledge and common sense can impact your option profits.
Congrats.
Alan
11 GaryM // Jan 28, 2010 at 5:01 am
Eric,
Thanks for sharing. Good stuff.
12 Aaron // Jan 28, 2010 at 7:15 am
Alan,
What is your opinion about BERKSHIRE HATHAWAY’s Class B shares?
Ticker on Yahoo is BRK-B, E*Trade = BRK.B
Not sure if being listed on the S&P would be a reason to pop, or a reason to flop.
Options premiums are fantastic. I have some ITM Feb 72 Strikes, but not sure if things could fall apart.
Interested in your opinion and to share the stock with other options traders here as well.
Thanks
13 Aaron // Jan 28, 2010 at 7:18 am
Eric,
Congrats on your roll up!
I was in a similiar situation recently with STEC…I know STEC is having some issues, but the options premiums have gained me some good bucks…and the last cycle getting assigned was a blessing at 19!
To tie in your experience…I had some lower OTM strikes in STEC…and the price was moving up and up…so I ran the numbers and it was more beneficial to buy back the contracts and STO at a higher strike to make a great underlying pop!
I love options!!!
14 Joshua // Jan 28, 2010 at 8:48 am
Eric,
question, what happens if you’d sold another ITM strike 35 call and the stocks did not get assigned since the price on end of cycle is below 35? what would your costs be? what would the returns look like?
15 Rob K // Jan 28, 2010 at 12:56 pm
I know that the way Eric did the calculations is how the calculator tells us to, but I have a hard time wrapping my head around the concept of “buying up.” By using this concept, Eric saw some impressive percentages. But that buy up money only works if he is not locked into an option. Since he sold the 36 dollar, that bought up profit cannot be realized (and used) unless he either buys the option back or the option expires.
Now, one would hope the option expires at around that price. But as of now, PXP is 33.95 and the only realized money is the loss taken to buy the lower strike price and sell the higher. That percentage is only potential.
Someone please correct me if I am wrong here.
16 Aaron // Jan 28, 2010 at 6:57 pm
Rob K,
I’ll chime in.
Rereading Eric’s comments, he said he does have the potential of over 10% by buying up or rolling up.
Since it is a Feb call, he still has time for it to get assigned at that price or near that price.
You are correct, if the price sinks to 33 or lower, then his idea of trading premium gain for more underlying equity gain would not work…and if he had to pay more in buying back then the original premium he received on his first covered call…then he would be down in cash on this deal.
My example with STEC for January…I had bought the stock at 15, wrote a CC at 16 for ‘x’ amount…the stock was going up…I did a BTC at a higher price then what I got in premium for the original sale…but then I rolled up and wrote a 16 and made a little bit of money on it…STEC went up further, and I did a buy back, at a loss, rolled up and went for 18 or 19…can’t remember now…made some premium money…not much…it got an early assignment, surprisingly…so I gained much more in the equity pop then I would have with pure premium alone.
I always run the numbers to see if it is worth the buy back and rolling up in the same trading window…or as Alan likes to call it, Hitting a Double.
To sum up…to buy up or roll up, you are already in a ‘open’ position…so you would have to close your existing position, and then sell to open at the higher…or lower strike.
Hope that helps?
17 Rob // Jan 28, 2010 at 7:08 pm
Aaron,
I understand what you mean. Thanks for the detailed reply.
When I think of hitting a double though, I think of receiving a premium in my account immediately — I made two premiums in one month. From the second trade, Eric receives no money in his account. In fact, he takes a loss. The only way he sees that new money is if the contract expires and he can sell at that price or it is called away.
The big thing for me is to always identify POTENTIAL profit versus realized.
18 Eric R // Jan 28, 2010 at 7:33 pm
Wow… didn’t realize there would be an entire discussion about this. Great insight from everyone.
Yes Rob, I took a loss on the option, but the BTC allowed me to lock in that time value that had eroded in the option. Am I taking a risk that the stock will fall (which it has today) making my decision a bad one?.. yes, but it was one I was okay in making given how this stock was acting recently.
Your point about showing a loss in my account by buying back my option was the exact point I was making last week to Alan on how I should track this in my option log. I was having a hard time getting my head around how it tracks, but until you realize the equity gain (hopefully) by selling it will look like a loss on the trade. The BTC transaction and the ‘buying up the value of the stock’ as Alan puts it effectively cancel each other out meaning you now own the stock at the market value.
On this stock I will now look to BTC if the stock keeps falling to relieve myself of the obligation and possibly hit a double on the same strike.
Thanks
Eric
19 Aaron // Jan 29, 2010 at 5:30 am
Rob,
Not sure if I get you 100%, but you can make money doing a buy back and then rolling up or down.
Sorry if I am off track, but if I write a CC for a strike of 15 and I get a dollar in premium…then a week later, it drops to .5, I do a BTC, I then have finished my obligation and pocket the fifty cent difference.
In this case, I would consider rolling down to maybe a 14 strike if it makes fiscal sense.
Another situation is after I did my BTC, a news story comes out and the stock skyrockets and then I resell another 15 CC for 1.2 or even for 16 @ .75, I’ve hit a great double.
But perhaps your question is in the fact of counting your eggs before they have hatched…and I agree…it is good to see potential…but I wont pen the value until all is said and done!
20 Rob K // Jan 29, 2010 at 6:00 am
Aaron,
You got it. That is exactly what I meant.
21 Don B // Jan 29, 2010 at 10:37 am
Gents:
Your discussion on BTC situations is quite interesting. But I learned something only recently that I had not thought of before. Today I did BTC on three different issues. There are 3 weeks left in the February cycle. In the past I would have simply left them, hoping for a turnaround (stocks are falling). (Right, hope is not a strategy.)
Finally dawned on me that any turnaround would not be more profitable had I just sat, and not tried an exit strategy which, if it does turn around, will increase the gain over what it would have been. The BTC cost is, after all, quite small. Now I have a chance for three doubles! Just a thought FWIW.
Don B
22 Aaron // Jan 29, 2010 at 11:20 am
Don B,
Good observation…the markets are in the water closet so to speak…so a BTC might be a great opportunity to lock in your gains…and still have a good solid week before the two week shut down.
…things might turn around and you can hit a double on all three!!!
Good luck!
23 Rob // Jan 29, 2010 at 12:35 pm
Don B,
No doubt. I have been exiting and selling all this week. I have no made huge gains, but i am done well at protecting premiums I have already received.
Not to mention I find examining all the possibilities extremely fun.
24 Eric R. // Jan 29, 2010 at 12:51 pm
Alan –
I know you are enjoying your cruise right now, but I’d be curious to hear how you have handled CYD since you last talked about it. Given the recent hiccup with the market it seems many stocks have gotten hit hard. One I noticed was CYD which is down about 25% since you talked about rolling out for the Feb contract. I assume if you still own it you have aleady BTC this contract, but have you rolled down yet? I think this is where my experience is lacking in understanding how to handle certain situations when stocks are falling hard.
If anyone else has cases where they have managed to eke out a gain or small loss on a stock falling hard like CYD I’d be curious to hear. Dave mentioned JOYG above… which is one of my less than spectacular holdings right now.
Thanks
Eric
25 Dave D // Jan 29, 2010 at 4:22 pm
Alan,
To echo what Eric R said, I also lack understanding in how to handle situations when the stock is falling hard…
From what I see it, there are 3 options…
1) Roll Down
2) Sell
3) HOLD ON!
Alan, how do you handle situations when stocks are falling hard like they are currently doing?
Dave
26 Don B // Jan 29, 2010 at 7:57 pm
Dave D – (post #25 )
You outlined the choices beautifully. What might make a good addition, a 3A so to speak, would be to hold on to the stock while doing BTC on the options – since if the stock turns around and rises one could then re-sell at a higher premium. This in a manner I somewhat poorly explained in my post #21.
Lotsa luck.
Don B
27 admin // Jan 29, 2010 at 9:48 pm
To all,
Linda and I will be returning to the U.S. late Sunday and will start repsonding to your emails and posts on Monday. Should be all caught up by weeks end.
Sounds like we had another rocky week on Wall Street. With 3 weeks remaining until expiration there is still time for recovery.
My best to all,
Alan
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