exchange traded funds Covered Calls With Exchange Traded Funds

Exchange traded funds are collections of stocks that trade like a single stock. Many of them are optionable (meaning there is a market for puts and calls on the ETF) so you can use them for covered calls. They are funds that are traded on an exchange with prices that update continuously during the day.

Some exchange traded funds track specific indexes, allowing you a low-cost way to trade the index. For example, the symbol IWM represents an ETF that is comprised of 2000 stocks that make up the Russell 2000. When you buy IWM you are buying a basket made up of 2000 stocks. Other popular ETFs include QQQ (NASDAQ 100) and SPY (S&P 500).

Other ETFs track specific countries, sectors, or commodities. For example, EWJ tracks Japan, EWZ tracks Brazil, XLF tracks financial stocks, and GLD tracks gold.

Exchange traded funds can make sense for covered call writers because of the built in diversification they provide (this is especially true in smaller accounts that may not have the capital to buy many different stocks for diversification). There is no single-stock risk with an ETF. If one of the constituent stocks drops suddenly then the effect will be felt less by the ETF that contains that stock than by the single stock itself.

Leveraged ETFs

However, there is one kind of ETF that you do NOT want to get involved with for covered calls, and those are the leveraged ETFs.

Leveraged ETFs are designed to be two or three times more volatile than an unleveraged ETF. You can usually recognize leveraged ETFs because they have words in their name like "ultra", "double", "2x", "triple", "3x", or "leveraged".

Leveraged ETFs are mostly the play thing of day traders and are not appropriate for income-oriented covered call investors. It can be tempting to do a covered call on one of these because the premiums are usually very high. But there's a reason for those high premiums! Leveraged ETFs are, by definition, 2x or 3x more volatile than their unleveraged counterpart.

Most Popular Exchange Traded Funds

If you're going to invest in ETFs for the purpose of writing covered calls, then you may want to stick to the more popular ETFs. You'll have smaller spreads on both the ETF side and the option side.

15 Most Popular ETFs (unleveraged) by Trading Volume (Oct 2010)
Symbol Name Avg Volume Market Cap
SPY SPDR S&P 500 208,948,000 $81.8B
XLF Financial Select Sector SPDR 89,519,400 $5.9B
QQQ PowerShares QQQ 81,723,100 $23.4B
EEM iShares MSCI Emerging Markets Index 64,725,900 $48.1B
IWM iShares Russell 2000 Index 63,025,900 $12.6B
VXX iPath S&P 500 VIX Short-Term Futures 24,189,000 $2.0B
UNG United States Natural Gas 23,925,700 $2.6B
FXI iShares FTSE/Xinhua China 25 Index 21,672,900 $8.6B
EFA iShares MSCI EAFE Index 20,820,000 $36.2B
EWJ iShares MSCI Japan Index 20,000,200 $4.0B
EWZ iShares MSCI Brazil Index 17,947,800 $11.8B
XLI Industrial Select Sector SPDR 16,775,700 $2.9B
XLE Energy Select Sector SPDR 16,557,600 $6.7B
GLD SPDR Gold Shares 14,840,000 $56.4B
SMH Semiconductor HOLDRs 14,449,600 $1.3B

Mike Scanlin is the founder of Born To Sell and has been writing covered calls for a long time.

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