Last month I published an article titled Complex and Leveraged Exchange-Traded Funds. I discussed the goals and risks associated with many of these products. One of the topics examined was Inverse Exchange-Traded Funds. Here is a brief review:
Inverse ETFs use derivatives to bet against the direction of financial markets. These are known as short or bear ETFs and will make money if markets decline in value. They will lose money, however, if markets move against the bet. Covered call writers who have a bearish market outlook may find these funds useful.
I highlighted the last sentence because we find ourselves in a market environment that is both volatile and slightly downtrending. While I remain cautiously bullish on the overall market many sophisticated covered call writers can benefit from the use of inverse ETFs in the short run. Over the long haul, shorting the market is NOT a sound strategy.
Advantages of Inverse ETFs over short selling:
- Retail investors can use these products to short the market without being required to achieve shorting privileges which usually will not be granted to retail investors
- There are no margin requirements as there are with traditional shorting
- The loss potential for shorting is unlimited (the underlying can appreciate exponentially) but limited to the initial investment for Inverse ETFs
- Costs associated with short-selling are avoided
- Some funds include professional management which will assist less experienced investors
Disadvantages of Inverse ETFs over short selling:
- ETF share prices may not be exactly correlated to the underlying benchmark which may result is lower-than-anticipated returns
- As a general disadvantage we must re-tool our thinking to make decisions when to enter and exit our positions as we have been trained to look for positive market movers
Inverse ETFs (non-leveraged) that follow closely watched indexes:
Inverse ETFs- Market Indexes
Recent short and long-term performance of Inverse ETFs:
Since the market historically appreciates in value in the long run, this is a short-term strategy that must be monitored carefully. Let’s first view a 1-month comparison chart of the four selected Inverse Funds compared to the S&P 500 as of 6-9-11:
1-month chart of Inverse ETFs vs. S&P 500
Now let’s compare to a 1-year chart:
1-year chart of Inverse ETFs vs. S&P 500
These two charts demonstrate how both beneficial and risky Inverse ETFs can be.
Options chain for Inverse ETF RWM:
RWM options chain
The 5-week return for the at-the-money $31 call is $70/$3100 = 2.3%
Conclusion:
The use of Inverse ETFs by experienced covered call writers in the short-term can be a way of enhancing returns in bearish market conditions.
Premium report:
When the market declines over a period of several weeks as it has recently even some of the strongest stocks will not meet the strict BCI criteria. Many of you noticed that last week’s report had only 20 stocks, of the thousands reviewed, that passed our screens. One of the choices we have in these circumstances is to look to the exchange-traded funds that meet the BCI screens. New members should note that we also publish a weekly ETF report that is located in the “resources/downloads” section of the premium site. Once the market rebounds, the number of eligible equities will return to the normal level (40-60).
Market tone:
Despite a rough six weeks recently, I remain cautiously bullish on the overall economy. After last week’s disappointing unemployment report, this week’s reports were surprisingly positive:
- Consumer credit rose $6.2B in April, beating expectations
- The U.S. trade balance narrowed in April to $43.7B, exceeding expectations
- The Federal Reserve Beige Book survey showed that the economy continued to grow in all 12 districts
- A quote from Fed Chairman Bernanke: “Overall, the economic recovery appears to be continuing at a moderate pace, albeit at a rate that is both uneven across sectors and frustratingly slow from the perspective of millions of unemployed and underemployed workers.”
For the week, the S&P 500 declined by 2.2% for a year-to-date return (including dividends) of 1.9%
A 1-year chart of the S&P 500 shows a break below the shorter term support (50-d sma). Should the benchmark break below the longer term support (200-d sma) we will be faced with a strong bearish technical signal:
S&P 500 drops below the 50-d SMA
Summary:
IBD: Market in correction
BCI: Cautiously bullish selling only in-the-money strikes
Wishing you the best in investing,
Premium Members,
The Weekly Stock Screen And Watch List for week ending 6/10/11 has been uploaded and is available in the premium members area.
Best,
Barry
Premium members:
We have an enhanced our ETF Report to include an additional chart showing ALL Select Sector ETFs. Look for:
” ETF Top-Performers 6-9–11 – Rev A ”
in the “reources/downloads” section of the premium site. Here is a link to the site:
http://www.thebluecollarinvestor.com/member/login.php
Alan and the BCI team
Alan,
Can you have your team publish the stock report and list in larger print. I have some issues with my vision and would appreciate any help you can offer.
Richard
Richard,
I know some find reading online to be uncomfortable. However, if you are using a current version of the Adobe Reader, you should be able to magnify the pdf stock report on screen up to a level to suit your reading needs.
Alternatively, many browsers have a Zoom function that you may find useful. In Firefox Zoom In is
Finally, the major operating systems offer “accessibility” functions that can make text easier to see. Search for the name of your operating system and “accessibility” to see what is available.
Al
Alan,
Besides in the money options and these inverse etfs are there any other strategies we can use in down markets?
Thanks for this informative article.
Ted
He may be a boring investor, and he may invest like a girl, but, a private lunch with Warren Buffet went for $2,345,678. Yup. That’s not a typo, but because the bidder wanted to top last year’s $2.6 million bid, the winner is contributing an additial amount to bring the winning bid to $2,626,411. Somehow I think, “Do you want your pickle?” is NOT going to be one of the primary questions asked.
Ted (#2),
There are several bearish strategies in general like buying puts, certain credit spreads and short-selling. As it relates to covered call writing, in addition to the strategies you mentioned, we can also favor low-beta stocks. These are equities that historically have less volatility than the market in general. If, for example, a stock has a beta of 0.5 and the market declines by 2%, we would expect that stock to decline only 1%. If, on the other hand, the market is up 2%, this stock would be expected to appreciate only 1%. Low beta stocks tend to outperform in bear markets and underperform in bull markets. Beta information is included for all stocks in our premium report.
Alan
Richard (#4),
Let me add this to Al’s very helpful comments: See the picture below which will guide you to the dropdown where you can control the size of the letters and numbers. Click on image to enlarge and use the backarrow to return to this blog.
Alan
Alan,
If I buy an inverse ETF as short term protection for my covered call positions in case of a more severe or continued market pullback it seems wrong to sell a call against it and limit the protection. Am I missing something?
Thanks,
Mark Tooker
Mark,
The general concept is the same: You are generating a cash flow from an appreciating asset or at least one that is not declining in value. The difference is what is making the underlying appreciate. In normal market conditions it is the momentum of an uptrending market along with strong equity fundamentals and technicals. In the case of inverse ETFs it is the bearish market that is causing our underlying to increase in value. One of the reasons it took me years to bring inverse ETFs into the discussion is that we must view the parameters through difference glasses.
Now to protect your overall portfolio you can use inverse ETFs or buy puts but here we are hedging rather than looking to generate a monthly cash flow. Your point is a good one because inverse ETFs can be used for covered call writing as discussed in the article but also to hedge one’s overall portfolio.
Alan
VXX:
I’ve had a few inquiries on this product.
Interesting Q&A just posted on last week’s article. See comments # 41 and # 42:
http://www.thebluecollarinvestor.com/blog/flash-trading-the-pros-and-the-cons/#comments
Alan
In my mind, buying a an inverse ETF and a regular ETF, even if you are selling calls against both, is like putting money on both black and red on the roulette wheel. Sure, one of them will be right, but the amount you stand to make is hardly worth the effort.
If you are bearish, take a bearish stand. Buy the inverse ETF, and sell a covered call. If you are bullish, buy a regular ETF, and sell a covered call. If you aren’t sure, pull your money off the table and go to the buffet.
Owen,
As usual you make a very good point!
However as is usual for me I tend to complicate it. I have covered call positions on individual stocks which are weathering the downturn ok but the Russell for example is falling more than the S&P and the Dow. I bought some TWM which is a triple leveraged inverse ETF. I thought I might make a little and it is also a hedge if things drop more. I guess the question I have to ask myself is, is it a hedge or a bearish stand. If its a bearish stand I should sell calls where if its a hedge I might not want to limit the protection by selling calls.
Having said all that, the last time I tried leveraged ETF’s I swore I would stay away from them and here I am in one again.
Mark Tooker
Correction, TWM is a double leveraged not a triple. (Its still scary)
Mark Tooker
Anyone have any experiences with weekly Covered Calls? There are about 60 or so and some are ETF’s. I had one person report that they make between $1000-1700.00 per week doing this (with the exception of the regular Monthly expiration) which excludes the weekly I believe. Can we use any of the tools we have with BCIand has anyone tried these?
Mark T,
I have previously expressed my displeasure with the leveraged ETFs. Not only can you increase your profit with leverage, you can increase your loss with it, too. I do not think they are good choices for most of the BCI. You can actually create a leveraged ETF out of any ETF, if you really want to. Take $2,000 and use margin to buy $4,000 worth of SPY. Voila, a leveraged ETF. Not a smart move for most people, but it is leveraged.
JimB,
The weekly calls are mostly on expensive stocks, such as PCLN, AAPL, NFLX, IBM. Using the BCI screens will probably eliminate most of them. Then, putting up enough money to buy 100 shares, will take a lot more capital than most trades the BCI are accustomed to. I have used a few spreads on the weeklies, from time to time, but putting up $33,000 to buy 100 shares of Apple is more than I am willing to commit to earn a $400 call premium.
Alan,
Since options expire this Friday can you provide a link to the expiration Friday video you previously showed on this site?
Thank you.
Karen
Karen,
I’m happy to share that link:
http://www.youtube.com/watch?v=5EAbcO4IzD0
Alan
Has anyone looked at the $BXM BuyWrite Monthly Index and from that determined if it is safe to be in OTM or ITM depending on its technicals and chart? I know there are many other ways to determine bullish and bearish sentiment, but just wondering if $BXM would be a confirming indicator? Thanks
This is truly a great and educational website and the sharing of info it provide is awesome.
Jim
Actually, I see Alan wrote on this on April 30th so there is no need to respond to my question. I have the symbol wrong anyway. There is a treasure of information on the left side of these pages if one just care to stop and read.
Jim
Jim,
You make an interesting point regarding BXM. This index sells 1-month out-of-the-money calls on the S&P 500 stocks and will closely mirror the S&P 500 itself. Over the long-term it will slightly outperform the benchmark with less volatility. So the question is are we better off using the benchmark or the BMX index as one of the parameters in determining our strike selection. My personal preference is the actual benchmark rather than the BMX as I want to be aware of current market volatility rather than a smoother version of the chart when making my investment decisions. Good point and interesting question. Thanks for sharing.
Alan
Alan,
Can your weekly stock list also be used for just buying and selling stock? If they are good for covered calls they should also be good for ownership too?
Thank you
Meryl
Meryl, I like to share my opinion on your question and it is just that…my opinion. You bet they are. What comes to mind then, why limit possibly your upside with covered calls you might be thinking. Well here is my opinion once again. You can have your cake and eat it too. Sell the call and with a portion of the premium buy another call with a higher strike price. This will allow you to participate in any major move upward so your winners will not get away. Of course in this market environment I would not be doing it due to the downside risk. But in a bull market this could be an “option”. Remember however this will eat into your expected income you would normally get. However if done with one or two stocks in your portfolio could give you more bang for your bucks. Just my opinion.
I agree with JR. These stocks are among the best fundamentally and technically and should work well in most market conditions.
Fred
Premium members:
This week’s report of top-performing ETFs and analysis of ALL Select Sector Components has been uploaded to your premium site.
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
I have some stocks that I own that pay dividends next month. Example T. I currently have a covered call that expires tomorrow. (I also have some shares with the deep in the money LEAP option for dividend stocks). I am trying to compare selling monthly covered calls on this position to selling deep in the money LEAP options. I will see how this works over a year.
T was the only covered call for June that I still hold as all of my other calls were Buy to close following the 10-20 exit strategies (never had so many this happened with in one month!)
I am not planning to roll forward the covered call to July due to the dividend and probable early exercise. Would it make sense to sell an August call before the dividend, or will that also be in danger of early exercise? Or should I wait till after the ex dividend date to sell another call on this position? Estimated exdividend date for T is July 7 based on last year dividend schedule. My question is basically how far out do you have to worry about early exercise before payment of a dividend? Is it usually limited to the near option month?
A subjective question for discussion as we are all trying to figure out what to do for next month options. As I said in my prior post, rolling forward was not an issue this month as most of my options were bought back using exit strategies. Great as I kept most of my option premiums for the month. In some cases I immediately sold the position after the exit strategy if the stock fundamentals and technicals were not holding up. In other cases I still have the stock.
The question is the feel for this market. Are we nearing a bottom, in which case I should sell out of the money calls, or is there more room to fall, in which case I either sell in the money options and/or consider cash or portfolio protection.
I am on the fence personally, everything I read seems to be so pessimistic right now. But my contrarian nature says be prepared for the market to go up. Or is this one of those uncertain times when I should hedge my bets?
Patricia (#26),
Great question! Early exercise of options prior to the ex-dividend date is something I have been exploring recently as many of our members have been “turned on” by a discussion of increasing dividend yield through the use of LEAPS. I will be addressing this subject in my July 12th seminar in NY. There are several factors that will determine whether your option is exercised. Here is a brief outline taken from upcoming 3rd book:
Conditions for early exercise (rolling our option may avoid early exercise when these criteria are identified):
1- The option must be trading at parity (equal to the intrinsic value): If the option is trading at more than parity, the option holder should sell the option and purchase the stock at its current market price. Most deep-in-the-money calls will be trading at parity.
2- The option must have a delta close to 1: This will ensure that the option and the stock have the same characteristics so that the option holder is not losing out on any time value. After speaking with options insiders I have come to the conclusion that a delta @ 0.95 or higher will most likely lead to early exercise prior to the ex-dividend date.
3- Volatility considerations: Options in low-volatility markets are exercised more frequently than those in high-volatility markets.
4- Time to expiration considerations: With all other factors being equal, the delta will rise as we approach the expiration date. This will increase the chance of early exercise. Those selling deep-in-the-money LEAPS to increase dividend yield may want to consider rolling the call option as the delta approaches .95.
To sum up: If the option has no time value and a delta of 0.95 or higher and is near expiration, early exercise is likely and rolling the option should be considered.
Alan
LULU:
This stock has been on our premium watch list for 8 weeks. It boasted a steller Q1 earnings report with revenues up 35% and earnings up 16% ahead of eastimates. LULU has shown an average earnings surprise of 24% over the past 4 quarters. Gross profit also climbed to 59% from 54% last year.
This manufacturer of athletic apparel noted same store sales up 16% and direct sales rose by 51%. The valuation ratios are a bit high with a PE of 34x and a PEG of 1.6.
Our premium watch list shows the industry segment ranked at “A”, the beta @ 1.33 and the next ER date to be 9/10/11. Check to see if this equity deserves a place on your watch list.
Alan
Hi Patricia (#27),
Thanks for your comment. I really hope some of the experienced and successful people on this blog reply to it. I am in a similar position as you and would love to see their response.
All of my June covered call positions met the 20%/10% exit strategy for buying back the calls early. Most of them I closed the entire position, but I still own the underlying stock for two of them. (Note that I am just papertrading as I try to learn Alan’s strategies.)
Like you, I wonder whether the market overall will continue down or recover some in the next month. As I see it, this is a critical decision that must be made each month in order to decide where to sell options. Hopefully some months are easier to figure out than this upcoming one….
Given the current market uncertainties, I will be using ITM calls for all of my new covered calls because I am conservative. The question is what to do with my two stocks leftover from last month… Most likely I will simply sell the stocks because they don’t look like the best “financial soldiers” available for this coming month.
Again, I hope others will share their thoughts about the overall market for the coming month.
- Mark
Mark, Alan has stated many times and everyone really needs to understand that ITM is the right and correct option for a bearish environment. Dan Sheridan on CBOE TV ( available on the CBOE site) under resources — where they have many videos on option strategies– points out that for the past year Covered Call writers have made lots of money because of the bullish market. However, they need to change their tune if they want to survive a down market in using that strategy. ITM or collars is the best bet. Alan has stressed tITM and you are on the right track if you consider ITM for July. Of course the income is not as much but you have down side risk protection. Just my 2 cents worth.
JR
Radio interview:
A replay of a radio interview I participated in is currently being aired:
http://www.TheBusinessAuthorsShow.com
Alan
Thank you, JR. Your comments were helpful in solidifying my plans and expectations for the near future.
I have already opened 2 (papermoney) positions for July, one with 3.2% downside protection and the other with 5.2%. I hope this is enough… Last month I had a position with 6.6% downside protection and still managed to lose about 5% on it.
I don’t mind only getting 1.5-2% return on writing covered calls during difficult (bear or choppy) markets, but I really don’t want to have more than a very occasional losing month.
By the way, thanks for the reference to the Dan Sheridan video. I will definitely check it out. I have watched a bunch of his videos in the past and love them. I know some people can’t stand him because he is quite a “goofball.” I think he knows his stuff and explains it well, and I don’t mind his quirky sense of humor.
Thanks again,
Mark
Strike selection:
Here is a link to an article I published last year on this subject:
http://www.thebluecollarinvestor.com/blog/the-philosophy-of-strike-selection/
Alan
Hi Alan (#34),
Thank you for pointing to that article. It was a great answer to the question about strike selection. The comments from you and others following the article were helpful as well on the topic of handling losing positions.
Thank you for running this blog. I appreciate your willingness to help others learn what has worked for you.
- Mark
Alan, #34
Wow, Great article. It really clarifies my thinking on when to use ATM, ITM and OTM. I bookmarked the article. Thank you!
Also, thank you for your answer on my questions yesterday about T and deciding how possible early exercise affects rollforward decisions. I was not successful at rolling forward my June contract today. So I guess I will be called out of my position. I would like to reenter the position as I am trying to compare my experience with the monthlys to the deep in the money LEAP strategy. Would it make more sense for me to reenter the position right away, or to wait till after the ex-dividend date in early July? Or does it matter? Is there a rule of thumb for entering a position when a high yielding stock is near its ex-dividend date?
Thanks for your insights.
New question. I have some covered call positions that closed one penny above the strike price. Does this position get called and thus have to pay a commission that will be greater than the net benefit? Do I have any choice on exercise or is it automatic?
Patricia (#36),
The first decision I make when this dilemma exists is to define my goals. Is it 1-month covered call generation of a monthly cash flow or increasing dividend yield of high-yielding stocks? If it’s the former, the ex-dividend date plays no role. If the shares are assigned, I’ve made a great 1-month return and move on. If it’s the latter, I may want to role my near-term deep I-T-M LEAPS.
Alan
Patricia (#37),
Years ago the option strike had to be at least $0.10 in-the-money to expect exercise. Nowadays we see exercise even for a penny. Brokerages may be motivated to exercise simply to capture the commisssion. The process is random as the option is sent by the OCC randomly to brokerages who will assign randomly to their clients. You have no control over the process unless you roll your option prior to 4PM EST Friday. If assigned you will pay a commission on the stock sale.
Alan