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Exchange Traded Funds (ETFs) and Covered Call Writing

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.

Definition:

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:

BXM vs. the S&P 500- 1 year chart

BXM vs. the S&P 500- 1 year chart

__________________________________________________________________________________________
The Blue Collar System vs. the BXM Index:
Here are the reasons why we get better returns:
1- We are not required to hold every stock in the index; we can select only the greatest performers in the greatest industries.
2- We avoid earnings reports which you cannot do with ETFs.
3- We can utilize different strikes and not just O-T-M strikes.
4-We can initiate exit strategies which gives us greater control in elevating profits and minimizing losses.
Once again, let me mention that the advantages of the BXM Index and other ETFs are the lower time and cost requiremnts.
The approach that is best for you can only be determined by you. But by having the knowledge and evaluating it unemotionally, you will have the opportunity to make the decision that makes the most sense for your portfolio.
Market Tone:
The charts below depict a consolidating VIX and Banking Industry and an uptrending S&P 500. This is quite encouraging. I should note that historically recessions show three distinct bottoms (technically) and we have seen two so far ( November and March). Many chartists would suggest that we will test our lows one more time before heading north for the long run.  The truth is that these economic times are so historic and unique that the past may not be as predictive of the future as in more normal times. The point I draw from this is that improvement is definite; time to celebrate is not as apparent. Here are the charts:
VIX as of 4-3-09

VIX as of 4-3-09

Banking Industry 4-3-09

Banking Industry 4-3-09

S&P 500 4-3-09

S&P 500 4-3-09

_____________________________________________________________________________________________
Last weeks economic news:
The one big negative this past week was the increase in the unemployment rate to 8.5%, the highest in 26 years. Several positives included an increase in consumer confidence, construction spending beat expectations, factory orders rose for the first time in six months, and the manufacturing indusrty continued its modest recovery. For the week, the S&P 500 was up 3.3% for a year-to-date return of -6.0%.
_____________________________________________________________________________________
Replay of radio interview:
For those who missed it, WNB Radio Network is replaying an interview I did several weeks ago. It will play all weekend:
Let’s hope for more good news this week,

Tags:

About Alan Ellman

Alan Ellman loves options trading so much he has written four top selling books on the topic of selling covered calls, one about put-selling and a sixth book about long-term investing. Alan is a national speaker for The Money Show, The Stock Traders Expo and the American Association of Individual Investors. He also writes financial columns for both US and International publications along with his own award-winning blog.. He is a retired dentist, a personal fitness trainer, successful real estate investor, but he is known mostly for his practical and successful stock option strategies.

22 Responses to “Exchange Traded Funds (ETFs) and Covered Call Writing”

  1. Barry Bergman April 4, 2009 11:44 am #

    Alan,

    To get greater diversification, your readers might consider a portfolio of ETFs that cover different market segments such as large cap, small cap, international, emerging markets, etc. Other ETFs can be included that focus on the specific industry segments that are performing better for a given market condition.

    Barry

  2. admin April 5, 2009 8:59 am #

    Email question from Karl:

    Alan,
    You mention in your video that if you go to the comments link you would post at least once a week possible CC plays. Can’t find it.

    Karl

    My response:
    Karl,

    I will post at least one cc example with calculations each week on the comments link of the current article. For example, check out comments 6 and 9 from last week’s article:

    http://www.thebluecollarinvestor.com/blog/reverse-stock-splits-and-how-they-effect-our-option-contracts/#comments

    Alan

  3. admin April 5, 2009 9:21 am #

    Check out my comments on top of page B 10 of this weeks (Monday edition) Investors Business Daily.

    Alan

  4. Barry Bergman April 5, 2009 7:27 pm #

    Alan,

    I saw your comments in IBD…glad they published them! With respect to those comments, have you finalized the new criteria yet for using the new IBD format?

    Barry

  5. admin April 6, 2009 1:18 pm #

    Barry,

    I have finalized the new criteria but want to make sure IBD makes no further changes to the enhanced site. Once the new site goes “live”, I will send out a FREE package to all those on my mailing list explaing the new screening process. It will be easier but just as accurate as our current system.

    Alan

  6. admin April 6, 2009 1:43 pm #

    Email from Dave R:

    Dave Ronyak // Apr 6, 2009 at 1:02 pm

    I came upon your website today while seeking information relating to tax treatment of options transactions (selling CC) for use in calculating my estimated income tax payments due for 1Q2009. I retired from corporate employment in 2008 and this is the first time ever I have had to deal with estimated tax payments. I am not certain whether I need to include these premiums in my estimates of my AGI for each quarter or not. I prefer not to “loan” my money to the government through overpayment of income taxes prior to their due dates.

    Would you please go into further detail regarding the above March 13 post using BWLD, and rolling into an April 30 call? It appears to me that the investor is giving up (or letting ride) 7.5% return in March and actually putting in more money in exchange for the opportunity to collect $460 at close in April on an investment of $3135 ($3000 + 225 – 360 + 460).

    Thank you for sharing your many insights and strategies.

    Dave R.

  7. admin April 6, 2009 2:05 pm #

    Dave,

    Welcome to the site…nice to have you aboard. Regarding your tax question, I’ll defer to our tax experts who follow this site. Keep an eye out and I’ll see if I can twist a few arms to respond to your question about tax estimates.

    I’m happy to respond to your question about expiration Friday exit strategies. To those who missed the post you are referencing, let me set it up:

    1- Jeff bought BWLD @ $30 and sold the Feb. $30 call for $225. This represented a 7.5% (225/3000) 1-month return.

    2- Near expiration Friday the stock was selling for $33.35.

    3- A rolling out strategy would involve buying back the Feb. $30 call @ $3.60 and selling the March $30 call for $4.60. This would result in a $100 profit per contract (460 – 360).

    4- Since our cost basis (at this point in time) is $3000 per contract (we are obligated to sell @ $30), the return on the option exit strategy is 3.3% for 1-month (100/3000).

    5- Since we are selling the 30 call and the equity price is @ 33.35, we have downside protection of 11.1% (335/3000).

    Now to your questions:

    1- The 7.5% is profit already generated. Do not cloud your current investment decisions with last months profits. You earned that cash and it is probably already re-invested (compouind,compound, compound…..).

    2- As we approach expiration Friday, look at it as if you have $3000 per contract, not $3335 because of your contract obligation. What are you going to do with that cash? No action will result in the sale of your shares and $3000 in your account. The option buyback with the simultaneous sale of the next months same strike option will result in a 3.3% 1-month profit with 11.1% protection. This will make sense to do unless you can find a better place for that $3000.

    Ask yourself….”where is my money best placed at this moment in time?” Factoring in the past will hinder our non-emotional decisions.

    Hope this helps and keep an eye out for our tax experts.

    Alan

  8. Owen Sargent, CPA April 6, 2009 3:04 pm #

    Dave,

    There are two ways of calculating your estimates for 2009. The simplest is to take 2008 taxes, divide by 4, and send that in (or 110% for high income earners). You can calculate each quarter if you wish. Jan-Mar is due 04/15. You will treat the covered call premiums as income only if the position is closed in the quarter (bought to close, or exercized). If you sold an April call in March it is not a gain or loss until you buy it back or your stock gets called away. It is not income until then.

  9. admin April 6, 2009 5:07 pm #

    For those looking for an outstanding CPA to handle your tax needs in general and tax treatment of stock options in particular, I highly recommend Owen Sargent:

    osargentcpa@aol.com

    Owen played an integral role in the creation of the Ellman System Options Calculator (ESOC).

    Alan

  10. Brian C April 7, 2009 9:48 am #

    Alan,

    I recently read your book and am anxious to get started but I’m paper trading like you suggested.
    I do have a question about how you decide which strike price to use when you sell the option.

    Thanks for your help.

    Brian

  11. admin April 7, 2009 9:55 am #

    Brian,

    There is an art to this aspect of cc writing and paper-trading will be quite helpful in developing this skill.

    I use a combination of market tone, technical analysis of the stock and calculations to lead me to the best choice. Here is a link to an article I wrote recently on this very subject:

    http://www.thebluecollarinvestor.com/blog/selecting-the-best-strike-price/

    Welcome to the world of Blue Collar Investing!

    Alan

  12. admin April 7, 2009 1:09 pm #

    The enhanced version of the IBD website went “live” today. I will be sending everyone on my mailing list a FREE package of information explaining how best to utilize the new screen in our Cashing in on Covered Calls System. Expect to receive the updated information by this weekend. If you are not on my mailing list and would like to join, here is the link:

    http://www.thebluecollarinvestor.com/joinlist.shtml

    THE NEW SCREEN WILL BE EASIER BUT JUST AS ACCURATE AS THE PREVIOUS ONE.

    Alan

  13. admin April 8, 2009 12:58 pm #

    3.5% return in 7 days?

    With only 7 trading days left until April expiration is it possible to generate a great return without moving into the next contract period (May)?

    Let’s look at our old friend (for now) NFLX:

    Buy 100 x NFLX @ $44.28

    Sell 1 x April $45 call @ $85

    ROO = 85/4428 = 1.9% 7-day return = 68% annualized (about 250 trading days in a year)

    Upside Potential = 72/4428 = 1.6% (if stock surpasses the $45 strike)

    Total possible 7-day return is 1.9% + 1.6% = 3.5%

    Risk: Since we are selling a slightly out-of-the-money strike, we have no downside protection. This is the sort of deal I would do if the technicals are looking great (they are) and the market tone is positive (it’s not).

    Set up a chart of this stock as per page 85 of “Cashing in on Covered Calls” and see why I would be more inclined than not to do this deal if I had the extra cash in my account.

    Even at this late date in a contract period, it is possible to generate great returns if you have a quality watch list.

    Alan

  14. admin April 10, 2009 11:16 am #

    Cute video explaining the credit crisis:

    http://preview.tinyurl.com/bccredit-video

    Then click on “proceed to site”

    Enjoy,
    AQlan

  15. Brian April 22, 2009 1:47 pm #

    What do you think of closed-end stock funds? They are trading at a good discount to NAV and offer some diversification?

  16. admin April 22, 2009 6:55 pm #

    Brian,

    For those readers not familiar with closed-end funds, they are publicly-traded investment companies that raises cash via an IPO. They are actively managed by an advisor and concentrate on a specific market, industry or sector.

    Brian, although I agree with your assessment of these funds in general, for the purpose of writing covered calls, a conservative strategy, I prefer ETFs geared to an index like the S&P 500, total stock market or the Nasdaq tracking fund. Administrative expenses will be MUCH lower and price patterns perhaps more predictable, a big plus for cc writing.

    I would suggest paper-trading funds like BLK versus equities that pass our system criteria and then deciding which works best for you.

    Thanks for sharing your ideas,
    Alan

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