For the strategies of covered call writing and selling cash-secured puts, we are selling the right, but not the obligation, to buy or sell 100 shares of the underlying security. That security can be a stock or and exchange-traded fund (ETF). In this article, I will highlight ETFs and demonstrate a few approaches to funding our option-selling portfolios with these securities.
Pros and cons of ETFs
ETFs consist of a basket of stocks and, as a result, are instantly diversified to some extent. Therefore, to achieve appropriate portfolio diversification, we would require less cash to purchase the underlying securities. For individual stocks, the BCI guideline is that no one stock or industry should represent more than 20% of our total portfolios. Furthermore, ETF require less management because we are not concerned about earnings reports, so we can actually stay with an ETF indefinitely if it remains a top-performer.
Since ETFs are baskets of stocks (in most cases), some are going up in value, some down, so as an aggregate the implied volatility (IV) of the security is lower than that of a typical stock. A lower IV means lower option premiums so when using ETFs we should set lower goals for our initial returns. I use 2% – 4%/month in my portfolios with individual stocks and 1% – 2% in my mother’s portfolio with ETFs.
Considerations when selecting ETFs for option-selling
In the BCI methodology, we favor 1-month options (some members use weeklys and others longer-term options but most use monthlys as I do…all can work). Market segments fall in and out of favor with institutional investors so we want those currently in favor. As with stocks, we insist on minimum trading volume of 250,000 shares per day and adequate open interest for the associated options. To assess ETFs currently in favor, we compare the 3-month price performance to that of the S&P 500 and insist that the ETF is an out-performer with a relative strength (RS) rating greater than 60. In the chart below is an example of ETF out-performers taken from our Premium Members ETF Report (produced weekly for our members):
Exposure to the S&P 500 only
The Select Sector SPDRs are unique ETFs that divide the S&P 500 into 9 sector index funds. Many of our members use the current top 3 of these sectors to fund their option-selling portfolios as shown in the screenshot below taken from a Premium ETF Report:
Extreme bear market considerations
Although it is rare that we would resort to these securities (2008 was an exception), Inverse ETFs use derivatives to bet against the direction of the financial markets. These are also known as bear or short ETFs. Many have options associated with them as well as adequate open interest for the near-the-money option strikes. Since the market historically goes up in value in the long run, these securities historically go down in value but may have some value in unusual circumstances. Below is a screenshot taken from a Premium ETF Report showing the inverse ETFs under-performing the S&P 500:
Measuring ETF risk
Although most ETFs have less volatility than individual stocks as stated earlier in this article, there is still a significant range in IV from one ETF to another. By looking at the implied volatility of an ETF and comparing it to the implied volatility of the overall market (S&P 500), we can make an informed decision as to the risk involved when using a specific security and whether it meets our personal initial goals and risk-tolerance. Below is a screenshot of part of the implied volatility section of our Premium ETF Reports (this information can be obtained for free @ www.ivolatility.com):
ETFs can represent a valuable security to include in a covered call writing or put-selling portfolio. There are advantages and disadvantages as with every approach but the selection process is as important as when using individual stocks. Initial return goals, time for management and personal risk-tolerance play vital roles in deciding between stocks and ETFs.
Next live seminar:
February 6, 2015
Friday February 6th
4PM – 6PM
New seminar just added
May 18th, 2015: Denver, Colorado
7 PM – 9 PM
Details to follow
Alan’s article published in the January edition of the AAII Journal
Get the Dramamine! Market volatility caused by decreasing oil prices (good or bad?), concerns over the global economy and terror threats in Europe have caused investors to fear an upcoming bear market. The Swiss National Bank ended a program to support the euro vs. the franc, which disrupted the euro caused more volatility in the U.S. markets. However, after taking a deep breath, we see an expanding economy and flourishing corporate profits so perhaps cooler heads should and will prevail. Those who are inclined to stay in cash due to this volatility will note that the February contracts are 5-weeks long so staying on the sidelines for a week will still allow us to generate 4 weeks of time value on our option sales. This week’s reports:
- The Federal Reserve reported in its monthly Beige Book that from mid-November to late December economic growth was modest to moderate in 11 of its 12 districts (Kansas City…get with the program!)
- According to the Department of Commerce, retail sales declined by 0.9% from November mainly due to a 6.5% drop in gasoline sales. However, year-over-year stats were 3.2% higher than for 2013, a very positive number
- The Consumer Price Index (CPI) declined by 0.4% in December according to the Labor Department. This was mainly a result of a 4.7% drop in the energy index
- Removing the volatile food and energy sectors the CPI remained flat in December
- For 2014, the CPI rose by 0.7% and 1.6%, excluding food and energy
- Concerns regarding falling inflation may impact Fed monetary policy
- The Producer Price Index (PPI) declined in December by 0.3% mainly due to a 6.6% drop in the energy index
- For 2014, the PPI was up 1.1%, compared to the 1.2% increase in 2013
- Industrial production declined by 0.1% in December after a 1.3% rise in November, according to the Federal Reserve. The cause was decreased demand for utilities due to warmer temperatures. Excluding utilities, production actually was up by 0.7%
- Year-over-year, industrial production in December rose by 4.9%
For the week, the S&P 500 decreased by 1.2%%.
IBD: Uptrend under pressure
GMI: 2/6- Sell signal since market close of January 6, 2015
BCI: Cautiously bullish but favoring in-the-money to out-of-the-money strikes 2-1. Selling out-of-the-money puts is another way to navigate volatile markets.
My best to all,
Alan ([email protected])