Select Sector SPDRs are unique exchange-traded funds that divide the S&P 500 into nine sector index funds. They have the diversity of a mutual fund, the focus of a sector fund, and the tradability of a stock. Together, the nine Select Sector SPDRs represent the S&P 500 as a whole. However, each Select Sector SPDR can also be bought individually, providing you with exposure to a particular sector or industry group.
These securities all have options and can be used with our covered call strategy. Each week the BCI Team will do a 3-month technical analysis of the linear price chart of each sector and compare it to the performance of the S&P itself. The top 3 funds outperforming the market benchmark will be listed and considered to be among the best candidates for covered call writing in the near-term. We will also show a chart of all sector components (located in the premium site). These charts are available in the premium section of this site.
The nine Select Sector funds are:
The Consumer Discretionary Select Sector SPDR Fund – XLY
The Consumer Staples Select Sector SPDR Fund – XLP
The Energy Select Sector SPDR Fund – XLE
The Financial Select Sector SPDR Fund – XLF
The Health Care Select Sector SPDR Fund – XLV
The Industrial Select Sector SPDR Fund – XLI
The Materials Select Sector SPDR Fund – XLB
The Technology Select Sector SPDR Fund – XLK
The Utilities Select Sector SPDR Fund – XLU
Exchange-traded funds are securities that track an index or a basket of assets like an index fund, but trade like a stock. They provide the diversification of an index fund. Many ETFs have options associated with them and are therefore covered call candidates.
Disadvantages of using ETFs: The one glaring disadvantage is the lower return generated by using these funds as the underlying security rather than individual securities. Expect returns between 1 1/2% and 2% (per month) rather than 2-4% in normal market conditions. This is a result of the fact that we are using a basket of stocks which reduces the overall volatility of the underlying, making the option premium less valuable. For this reason I prefer individual equities but will use these securities in certain situations (earnings season and my mother’s more conservative portfolio, for example). These are also appropriate for ultra-conservative investors and during extreme market volatility.
Advantages of using ETFs:
- Instant diversification
- No concern about earnings reports or same store monthly retail sales reports
- Requires less of an original investment
- Less management needed
How to select ETFs for your Covered Call Portfolio:
Since we are dealing with a basket of stocks, fundamental analysis becomes less of a requirement. So I come back to what I consider the most critical factor to consider: What are the institutional investors doing regarding this security? To resolve this issue I compare a 3-month chart of the S&P 500 (“the market”) to various selected ETFs. The BCI team screens hundreds of ETFs each week and publishes the top-performers on our premium site. In this article we will focus in on the Select Sector SPDRS. Here is a sample bar chart which displays all 9 Select Sector SPDRS:
At the date of publication of the Premium ETF Report, we chart the top-three performers and compare it to the market benchmark. Here is one such chart:
- XLU- $34.50
- XLI- $32.50
- XLY- $38
Next, let’s assume a portfolio with cash available of $50k. We will set aside 2%-4% for possible future exit strategy execution. That leaves 3 securities and $48k to spend. We will give equal cash allocation of approximately $16k per security as we round off to the nearest 100 (we need 100 shares per contract). Let’s calculate:
Since we spent $48,700, we will have a cash balance of $1300 from our original $50k for possible exit strategy execution.
Next, access the option chains and enter the stats into the Ellman Calculator:
The 1-month initial return is about 2.5% slightly higher than normal due to the market volatility at the time this article was written. The cash generated per contract (not including small commissions) is as follows:
XLU: 5 x $66 = $330
XLI: 5 x $80 = $400
XLY: 4 x $120 = $480
The total cash generated is $1210.
The percentage initial return is $1210/$48,700 = 2.48%.
You will note that I used near-the-money strikes which generate the highest initial returns. Based on your market assessment you can take a more or less aggressive stance.
A positive week for the market was also highlighted by a series of predominantly favorable economic reports:
- The unemployment rate shockingly dropped by 0.4% to 8.6% in November. This was the result of stronger household employment data plus a reduction in the labor force. Are workers giving up on finding employment and leaving the work force? To be continued.
- The Conference Board’s index of consumer confidence rose to 56.0 up more than 15 from October’s reading
- U.S. manufacturing rose to 52.7 in November according to the ISM Manufacturing Index. This was the highest level since June. A number over 50 suggests economic expansion.
- Spending in residential construction was up 0.8% in October mainly due to home-improvement projects
- New home sales rose by 1.3% in October, a positive but still a slow pace
- US worker productivity rose by 2.3% in the 3rd quarter, below expectations. Companies may need to add workers to meet demand in 2012
- According to the Federal Reserve’s latest Beige Book the US economy grew at a “slow to moderate pace” between October and mid-November.
For the week, the S&P 500 rose by 7.4% for a year-to-date return of 0.9% including dividends.
As we would expect there was a technical improvement in market tone this past week. The chart below shows the S&P 500 breaking through resistance at the double-sided red arrow on high volume: