Writing Covered Calls on ETFs

Using ETFs Instead of Stock to Write Covered Calls

Note: This page is about writing covered calls on ETFs (Exchange Traded Funds) and not a review of ETFs (or Closed End Funds, for that matter) that incorporate a covered call component within the fund itself.

In recent years, the rise of ETFs has been nothing short of astounding. They have grown in popularity for both traders who can use them to target specific sectors, industries, and even countries as well as from investors who can use them to quickly construct a customized but broadly diversified portfolio with less expense than owning mutual funds.

[Although with all the ulra long, ultra short, and deeply targeted ETFs available now, they can also use them to construct ticking time bombs.]

Many exchange traded funds are also optionable - the Options Industry Council maintains a comprehensive list of ETFs on which you can trade options.

The question naturally arises - is writing covered calls on ETFs a good option trading strategy?

Advantages of Writing Covered Calls on ETFs

Proponents of writing calls on ETFs point to the diversification aspect of exchange traded funds, at least in the case of those ETFs that track larger indexes such as SPY (S&P 500), DIA (Dow Jones Industrial Averages), and QQQQ (the Nasdaq 100).

After all, it's unlikely that an entire index is going to crash 30% overnight. If you own an invididual stock, however, you're much more vulnerable (so the theory goes) to unanticipated shocks specific to that individual company.

Another advantage of using ETFs as part of a covered call strategy is the ability to target specific sectors. This is especially of interest to those who are proficient at, or rely on some form of technical analysis for, trading and trade management.

Individual sectors may offer better opportunities (and more choices) for selling calls than sticking with a broader market index.

Disadvantages of Writing Covered Calls on ETFs

On the flip side, there are a couple of disadvantages to writing covered calls on ETFs as well.

First, and in general, ETFs seem to offer lower premium levels compared to individual stocks.

It may be the very diversified nature of the ETF in question, since the index itself should have less implied volatility than its individual components held in isolation.

Of course, the more tightly an ETF drills down to track individual sectors and industries, the fewer the individual components there are, and the more everything tends to move in tandem. So while these premium levels may be higher, it's because volatility levels are higher.

This isn't necessarily a bad thing, as long as covered call writers understand why the premium levels on an ETF that tracks a specific industry are higher than one tracking a broad market index.

Second, I have a big problem with diversification as it's practiced and promoted by a self serving industry and media that doesn't give a shit whether or not you make money in the stock market.

Let's be very clear - the Diversification Theology embraced by the conventional wisdom crowd means diluted investing, not quality investing.

Index investing to me just makes no sense - in order to be "safe" I'm expected to invest in a large basket of companies that, while the basket may include some terrific businesses with strong balance sheets and durable competitive advantages, by its very definition also includes mediocre and subpar companies.

So it's OK for me to own exceptional companies like McDonald's and Procter & Gamble, but just to play it safe, I better make sure I own crap companies like Sears and H&R Block, too?

And for the John Bogle types out there who argue that the average investor is too stupid to be able to tell the difference ahead of time between an exceptional company and a crap company, I say, "Shame on you."

Thanks but no thanks - I'll pass on "gaining exposure" to either the broader market or specific pockets of it. I don't want to "gain exposure" - I want to invest in individual rock solid companies that will make me lots of money.

So how does all this tie in to covered call writing? I'm biased, of course, but I believe you do yourself a huge favor by only writing calls on high quality holdings (i.e. attractively priced shares of those "rock solid" businesses).

The stocks of high quality companies tend to fall less and rebound quicker than their mediocre brethren. And when you swim in polluted waters, it's just a matter of time before you get sick yourself.

Selling Calls on ETFs - Tips and Guidelines

OK - now that I've got myself all worked up, here are three general guidelines and tips if you're considering writing covered calls on ETFs:

Make sure there's sufficient liquidity in the ETF's options. Just because you can trade options on an exchange traded fund doesn't mean that it's well suited for covered call writing. An ETF with thinly traded options will typically have a large bid-ask spread which can seriously reduce potential profitability.
Avoid crazy volalitility ETFs. Obviously you won't make money writing calls if you avoid volatility at all costs. But if an ETF has a history of big or erratic moves, you're going to be better off looking elsewhere. The same thing goes for the Ultra-type ETFs that attempt to double (or more) the directional movement of the index or sector they track. Unless you have a lot of experience handling explosives, there will always be better (and saner) opportunities available.
Is the underlying ETF a conceivable long term investment? Notwithstanding my anti-ETF diatribe above, index investing is (probably) better than just spending your money on clothes or electronics. I'm being facetious, of course. Although index investing can arguably be considered a viable form of long term investing, it really depends on the nature of the underlying index. Like covered call stock selection, you want to select something that's worth holding for the long term should the trade move against you.