An ETF (exchange traded fund) is a collection of securities that trades like a single stock. Many ETFs have options available so investors can use them for covered calls. They make sense for covered calls because of the built in diversification they provide (especially true in smaller accounts). Because of the way they are constructed, there is no single stock risk. If one of the stocks that is part of the ETF drops dramatically then the effect will be felt less by the ETF that contains that stock than by the stock itself.
Many exchange traded funds track a specific index, allowing you a low-cost way to trade the index. Take IWM, for example, which represents an ETF that is made up of two thousand stocks that make up the Russell 2000. When you purchase IWM you are buying a basket made up of two thousand stocks. Other popular ETFs include the NASDAQ 100 (symbol QQQQ) and the S&P 500 (symbol SPY). And there are ETFs to track specific commodities, sectors, or countries. For example, EWZ tracks Brazil, EWJ tracks Japan, XLF tracks financial stocks, and GLD tracks gold bullion.
GLD is an interesting one given investor interest in owning gold. But one drawback is that GLD doesn’t pay dividends. However, by using covered calls you can generate monthly income from gold, too. Buy a gold ETF and write covered calls (at-the-money if you’re neutral on gold, or out-of-the-money if you’re bullish on gold). GLD is the most highly traded gold ETF and probably the best bet for covered call investing. UGL is two times leveraged and therefore quite volatile, and DGL has tiny open interest.
Much like gold, investors should always have some exposure to emerging markets for diversification. That is especially true considering the volatilities in the forex markets. But emerging markets information is inconsistent, hard to come by, and in a format that is difficult to understand. So it’s another good case for ETFs. The most common emerging markets ETF is the iShares MSCI Emerging Markets Index Fund (EEM), which has nearly $40 billion in assets. It is highly liquid, which is an attribute you like to see when investing in general, and specifically when writing covered calls. Another choice, if you want to limit your exposure to just China, perhaps, would be to use iShares FTSE/Xinhua China 25 (FXI) instead.
Despite all the benefits of using ETFs for covered calls, there is one kind of exchange traded fund that you should not get involved with, and those are the leveraged ETFs. They are 2 or 3 times more volatile than a their unleveraged counterparts. You can spot leveraged ETFs because they almost always have words in their names like “double”, “2x”, “ultra”, “triple”, “3x”, or “leveraged”. Investors who day trade love leveraged ETFs. Good for them. But that does not mean they are appropriate for covered calls written by conservative income-oriented investors (they’re not!). They can be tempting because the high premiums they offer. But the extreme volatility is the reason for those high premiums! Better to stick with unleveraged ETFs for writing covered calls.
Born To Sell’s site is known for covered calls. Without getting into esoteric math, there is a good tutorial that answers the question “What is a covered call?”
