A critical requirement of my covered call writing system is to be properly diversified by stock, industry and cash allocation. No one stock or 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 $25,000 to $50,000 or more. By writing calls on exchange-traded funds (ETFs) each share represents a basket of stocks and therefore is instantly diversified. 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 as little as 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 with individual equities compared to the 1-2% for selling options on ETFs. This is because there is greater inherent implied volatility with individual equities than there is with ETFs.
Who should use ETFs:
Investors with limited cash to invest, with low risk tolerance or with time restrictions should consider writing calls on ETFs.
Advantages of ETFs:
1- Broad diversification- by definition an ETF inherently provides diversification across an entire index
2-Lower costs- Most ETFs are not actively managed thereby decreasing marketing, distribution and accounting expenses and most do not have 12b-1 (advertising and distribution) 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 1 1/2-2% 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, commodity, currency, actively managed ETFs and more. Here are three of the more popular ETFs for writing calls on heavily traded indexes:
- QQQ– follows a basket of 100 of the largest non-financial equities on the Nasdaq exchange.
- VTI– Vanguards security that tracks the total stock market.
- VV– Vanguards security that tracks the large cap universe.
- SCHB– Charles Schwab multi-cap (like total stock market)
- SCHX– Charles Schwab large cap (like S&P 500)
Major issuers of ETFs:
- Barclays Global Investors issues iShares
- State Street Global Advisors issues street Tracks and
- Vanguard issues Vanguard ETFs, formerly known as VIPERs
- Merrill Lynch issues HOLDRs
- PowerShares issuers ETFs and BLDRS (based on American Depository Receipts)
- Charles Schwab
Did you know that there are ETFs based on Covered Call Writing?
There are several relatively new ETFs that use covered call 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 one-month, out-of-the-money calls, similar 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 similar returns to the S&P index but with less aggravation. I created the chart below to show the comparison of the BXM Index (blue line) compared to the S&P 500 (black line) over the past 5 years:
The Blue Collar System vs. the BXM Index:
Here are the reasons why we get better returns:
- We are not required to hold every stock in the index; we can select only the greatest performers in the greatest industries
- We avoid earnings reports which you cannot do with ETFs.
- We can utilize different strikes and not just out-of-the-money strikes
- We can initiate exit strategies which give 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 requirements. 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.
Premium ETF Report:
Each week we scan the universe of exchange-traded funds to locate the best performing securities over the most recent 3-month period. These funds must have options, trade a minimum of 250,000 shares per day and are NOT a leveraged fund. We place the top 6 in graph format and list additional top-performing candidates. In addition, we chart the Select Sector SPDRs that are outperforming the overall market. These reports are available to all premium members. Below are two such charts from a recent report:
The use of exchange-traded funds has an important role in the world of covered call writing. As a Blue Collar Investor and CEO of our own money we must evaluate the pros and cons of these securities and decide if they are the right underlying vehicles for our covered call portfolio.
This week marked good economic news tempered by the threat of the fiscal cliff as Congress has been sending mixed messages. This week’s reports:
- The Department of Commerce revised 3rd quarter GDP from 2.0% to 2.7% (1.8% was expected) which represents the fastest rate of growth since the 4th quarter, 2011 and the best 3rd quarter performance in 5 years. This was largely due to an increase in business spending
- Sales of new homes slowed slightly in October as Hurricane Sandy impacted the northeast
- Despite this, new home sales are up 17% from October, 2011
- The median price of homes is up 5.7% from October, 2011
- Personal income rose less than 0.1% as an increase of 0.3% was anticipated
- According to the Federal Reserve’s Beige Book, economic activity grew at a modest pace nationwide
- New orders for durable goods were unchanged in October as a decrease of 0.1% was expected
- Consumer Confidence rose to 73.1 for the 3rd consecutive month leaving this barometer at its highest level since February, 2008
For the week, the S&P 500 rose by 0.5% for a year-to-date return of 15%, including dividends.
IBD: Market in confirmed uptrend
BCI: Despite the positive economic news, the threat of increased taxes and decreased programs for the middle class on January 1, 2013, this site remains cautious and favoring in-the-money strikes, low beta stocks and ETFs. Longer term, we are bullish and looking forward to becoming more aggressive in our trade positions as soon as economic stability is confirmed by Congress.
Wishing you the best in investing,