Select Sector SPDRs are unique exchange-traded fundthat 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:

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:

Top-three Select Sector SPDRS

  1. XLU- $34.50
  2. XLI- $32.50
  3. 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:

Cash Allocation

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:

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.

Conclusion:
The use of ETFs in our covered call portfolios has its advantages and disadvantages. Understanding these pros and cons will help us determine how and when to utilize these securities.
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Upcoming radio interview:
I was recently interviewed on Danielle Hampson’s popular Business Author’s Web Radio Program discussing covered call writing and my new book. The show will be broadcast on December 12th and 13th at the following link:
The show can be accessed at all times during these 2 days.
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Market tone:

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:

S&P 500 as of 12-2-11

At the same time the VIX dropped below 30 to 27.62 into our comfort level (red arrow) but barely:

VIX as of 12-2-11

Let’s say that we are pleased but not quite ready to initiate our victory dance for a raging bull market.
 
Summary:
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IBD: Market in correction.
BCI: Neutral, fully invested and selling mainly in-the-money strikes.
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My best to all,