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Exchange-Traded Funds: How They Operate: The Pros And The Cons

Covered call writers can use individual stocks or exchange-traded funds as the underlying securities. Each has its own set of advantages and disadvantages. In this article we will explore the mechanism behind ETFs and evaluate the pros and cons of incorporating them into our covered call writing portfolios.

When we buy one share of the Qs (Powershares Exchange-Traded Fund Trust – Powershares Qqq Trust, (NASDAQ:QQQ) for $55, 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 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 advantage 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:
  1. can be purchased on margin
  2. can be bought and sold @ intraday market prices
  3. can be traded with stop and limit orders
  4. can be sold short 

ETF Cons

  • Subject to market risk like investor sentiment and global conditions
  • Market pricing discrepancies (between NAV and actual share value) particularly in less liquid funds
  • Tracking discrepancies- returns may be more or less than the benchmark for the following reasons:
  1. A fund may sample the benchmark rather than duplicate it exactly
  2. Dividend distributions from a fund may differ from the equities themselves
  3. The expense ratio (administrative costs) reduces profits
  4. 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 mitigated by the others. Usually the greater the diversification, the lower the premiums because of  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: 

  • QQQ- Nasdaq 100 
  • IWM- Small Cap 

Other popular ETFs: 

  • DIA- Dow 30 
  • MDY- Mid-Cap 400

 Over the years I have used the Qs in my mother’s account with excellent success. More recently I have been utilizing the top performing ETFs and updating my portfolio on a regular basis. This information is provided weekly to our premium members. Here is a chart taken from a recent Premium member ETF Report:

 

Covered call writing with ETFs

ETF Report: Page 1

In the BCI methodology, we identify the securities that are outperforming the market as you see in the chart above before considering them as candidates for our covered call writing portfolios. Our members are provided with over 20 such securities each week.

Conclusion

ETFs are vehicles that can benefit both institutional and retail investors. For writers of covered calls, the main asset is its instant diversification that permits a conservative approach to an already conservative strategy.

Next Speaking Engagement:

March 21, 2013 6:00 pm – 9:00 pm

South Florida Options Trading Meetup

Many thanks to our members who attended my presentation for The Money Show @ the Marriott Marquis Hotel in NYC. It really made me feel special when I saw all those “Ellman-authored” books sitting out there in the audience. I’m sorry so many of you had to stand as we didn’t anticipate the amazing turn-out…Thank you!!!

Market tone:

Positive economic reports dominated this week with the fears of an $85 billion “sequester” looming which could result in severe government spending cuts:

  • Annual inflation rate remains below the Fed’s 2% target
  • The Conference Board index of leading economic indicators  rose by 0.2% in January boding well for continued economic expansion
  • Minutes from the January 29-30 FOMC meeting reflected a positive attitude regarding economic recovery citing improving housing, business investment and consumer spending as reasons
  • Consumer prices remained flat in January but up 1.6% from January, 2012
  • Producer prices increased by 0.2% in January
  • New residential construction dropped by 8.5% in January, however up 24% from January, 2012 which represents the 2nd best pace since mid-2008
  • Exisiting home inventories have declined by 25.3% from 2012
  • The median price of existing homes is now 12.3% higher than last year

For the week, the S&P 500 declined by 0.3% for a year-to-date return of 6.27%.

Summary:

IBD: Uptrend under pressure

BCI: Cautiously bullish favoring in-the-money strikes until “sequester” issues are resolved

Wishing you the best in investing,

Alan and the BCI team (alan@thebluecollarinvestor.com)

www.thebluecollarinvestor.com

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About Alan Ellman

Alan Ellman loves options trading so much he has written three top selling books on the topic of selling covered calls alone. He is a dentist by day, a personal trainer, successful real estate investor, but he is known mostly for his profound stock option strategies.

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7 Responses to “Exchange-Traded Funds: How They Operate: The Pros And The Cons”

  1. Barry B February 24, 2013 12:38 am #

    Premium Members,

    The Weekly Report for 02-22-13 has been uploaded to the Premium Member website and is available for download.

    Also, be sure to check out the latest BCI Training Videos and “Ask Alan” segments. You can view them at The Blue Collar YouTube Channel. For your convenience, the BCI YouTube Channel link is:

    http://www.youtube.com/user/BlueCollarInvestor

    Best,

    Barry and The BCI Team

    • Barry B February 24, 2013 9:49 am #

      Premium Members:

      This week’s Weekly Stock Screen And Watch List has been revised and uploaded to The Blue Collar Investor premium member site and is available in the “Reports” section. The Running List Notes and Guidelines section has been modified. Look for the report dated
      02-22-13-REVA.

      Best,

      Barry and the BCI Team

  2. Alan Ellman February 24, 2013 12:41 pm #

    Mini options:

    Several of our BCI members have inquired about these new products that are projected to launch on March 18th. Here is a brief overview:

    Deliever 10 shares on the underlying rather than 100

    Cost less to buy contracts on more expensive comapany shares

    Geared to retail investors

    Same expiration dates and strikes as standard contracts

    Will be available initially for the following 5 securities:

    AMZN, AAPL, GLD, GOOG and SPY

    Here is the response I have been sending to inquiring members:

    Hi (BCI member),

    Yes, I am monitoring the implementation of these new products which will become available on March 18th for 5 securities. This may be an exciting new product for retail investors like us but, in my view, it’s too early to be sure. I have several initial concerns:

    1- Are brokers and market-makers prepared to execute these trades in an efficient manner?

    2- Intuitively, one would expect the liquidity to be appropriate for trading but I would want to see first hand.

    3- What are the trading commissions? No word on that yet.

    4- This appears to be a product for retail investors only. How will the fact that institutional traders are not involved impact our trades?

    To be continued…

    Alan

  3. Alan Ellman February 26, 2013 6:41 am #

    Buying back options:

    With the market down dramatically on Monday most stocks had bad days. It is prudent to look at the premium value of the options sold at the start of the March contracts (including those of you paper-trading). The BCI guideline is to buy back (BTC) an option in the first half of a cycle if the premium is 20% or less of the original sale price. This will allow for the following:

    1- Guarantee retention of at least 80% of the original option profit

    2- Put us in a position to re-sell the SAME option if share price rebounds this week

    3- Put us in a position to roll down so as to mitigate losses if share price remains down or continues to decline

    4- Put us in a position to sell the stock if price and market declines persist

    I am making this entry on Tuesdeay morning pre-market when stock futures are higher but this is a situation that should be monitored.

    Alan

  4. Alan Ellman February 27, 2013 9:20 am #

    To all members:

    I have just agreed to host a webinar for The Money Show on Thursday March 7th from 4:30-5:30 PM EST. Admission is FREE. I will be posting a link to register once I receive it from the folks @ The Money Show.

    Alan

  5. Alan Ellman February 28, 2013 5:19 pm #

    Premium members:

    This week’s 6-page report of top-performing ETFs and analysis of ALL Select Sector Components has been uploaded to your premium site. The report also lists Top-performing ETFs with Weekly options.

    For your convenience, here is the link to login to the premium site:

    http://www.thebluecollarinvestor.com/member/login.php

    NOT A PREMIUM MEMBER? Check out this link:

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

    Alan and the BCI team

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