Would you like a quick, easy, inexpensive and still safe way to invest with covered call writing? If so, why not consider using exchange traded funds? In chapter 14 of my first book, Cashing in on Covered Calls, I discuss diversification and dollar cost averaging as an investment strategy and how that approach can be utilized when writing covered calls. I use this strategy in my mother’s account where I can generate significant and yet relatively safe returns (1-2 %/month) in normal market conditions.
An exchange-traded fund 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.
A critical requirement of my system is to be properly diversified both by industry and by cash allocation. No one industry should represent more than 20% of your portfolio holdings. Owning five different stocks in five different industries would require you to own at least 500 shares since each options contract represents 100 shares. This may require a cash allotment of $25,00 to $50,000 or more. By writing calls on ETFs, each share represents a basket of stocks and therefore, instant diversification.
There is also a benefit of a lesser time requirement. With individual equities, we are constantly changing our portfolio mix and factoring in earnings reports, technical and fundamental analysis. With ETFs, we are basically tracking just one security. Now if you are asking yourself why use stocks at all, the answer lies in the greater returns you will garner by writing calls on individual equities. In normal market conditions, a return of 2-4% is achievable compared to the 1-2% for selling options on ETFs.
Who should use ETFs?:
Investors with limited income, with low risk tolerance or with time retrictions should consider writing calls on ETFs.
Advantages of ETFs:
1- Broad diversification– by definition an ETF inherintly provides diversification across an entire index.
2- Lower costs– Most ETFs are not actively managed therefore decreasing marketing, distribution and accounting expenses and most do not have 12b-1 (advertising) fees.
3- Tax efficiency– ETFs have low capital gains because of the low turnover in their portfolios.
4- No need for a financial advisor– Why pay 11/2-2% a year to do something you could manage yourself?
5- Buying and selling flexibility– These securities maintain all the features of a stock, such as limit orders, short selling, stop orders and options.
Types of ETFs– Most ETFs are index funds and those are the ones I will focus on. For informational purposes, there are also leveraged (short), commodity, currency, actively managed ETFs and more. Here are three of the more popular ETFs for writing calls on heavily traded indexes:
1- QQQQ– follows a basket of 100 of the largest non-financial equities on the Nasdaq exchange.
2- VTI– Vanguards security that tracks the total stock market.
3- VV– Vanguards security that tracks the large cap universe.
Major issuers of ETFs:
1- Barclays Global Investors issues iShares.
2- State Street Global Advisors issues street Tracks and SPDRs
3- Vanguard issues Vanguard ETFs, formerly known as VIPERs.
4- Merrill Lynch issues HOLDRs.
5- PowerShares issuers ETFs and BLDRS (based on American Depository Recepts).
Did you know that there are ETFs based on Covered Call Writing?:
There are several relatively new ETFs that use cc writing in at least 50% of its portfolio. Here are a few:
LCM, BEO, DPD, FFA, MCN, and BEP. These funds haven’t proven themselves over time plus we aren’t sure what’s going on in the other portion of the portfolio. My gut tells me that if I was going with an investment vehicle that was actively managed, I’d prefer to manage it myself, thank you.
The CBOE S&P 500 BuyWrite Index (BXM):
This is a benchmark index designed to track the hypothetical performance of a covered call strategy on the S&P 500 Index.
It is based on buying the index and selling a 1-month O-T-M call, similiar to the Blue Collar System although we consider all strikes. A study done by Ibbotson Associates in 2004 came to the conclusion that a 16-year history showed the BXM to have a 12.30% return compared to the S&P 500 with a 12.20% return but with two-thirds the volatility of the S&P 500. This means that by using the BXM an investor can get similiar returns to the S&P index but with less aggravation. I created the chart below to show the comparison of the BXM Index (black line) compared to the S&P 500 (blue line) over the past year:
Click on the “MInd Your Bizness Program”.