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Finding the right ETF to execute a covered call on can be a daunting task. A list of all optionable ETFs can be found here:

First, we must limit our scope to find the right ETF. In order to sell a covered call, you must own at least 100 shares of the ETF. You will need to figure out how many shares you can purchase by dividing your capital by number of shares x cost \ 100. I’m using seed money of ~$40,000. So if an ETF is trading for $82/share the most shares I could buy would be ($40,000 / $82) = 487.80. I can only trade options in a set of 100 so this rounds down to 400 shares 487 \ 100 = 400.

If you only had $10,000 then you’d be limited to purchasing just 100 shares. Anything less than $8000 in your portfolio and you couldn’t buy any  ETF shares for this strategy.

We can clearly see that the lower the price of an ETF the greater number of shares we can purchase. The greater number of shares has the potential for a greater amount of profit. Conversely, a larger amount of capital has greater potential for increasing the scope and range of ETF choices as well as profit.

How do you pick a profitable ETF?
The long hard way is to go down the list and check the options for each ETF. This is how I initially did my investment research. I spent hours going through each ETF and its options, finding the right one with a high yield then preparing for the trade.

Here is a real life example:

XLE is an exchange traded fund (ETF) that specializes in the energy (oil) industry. As of 8/22/06, the XLE ETF is trading at ~$58/share.

xle8_22_06.gif

Taking a look at the options for September 06, we can see that the $58 strike options are trading for $1.40.

xle_8_22_06option.gif

So if we were to execute our strategy today with our capital we would.

1. Buy 600 shares of XLE for $58 (600 x $58) = $34,800 + commission.
2. Sell the September ’06 option for $1.40 (600 x $1.40) = $840 (our immediate profit) - commission.
3. Wait until Sept. 15th rolls around to see if we were called and our stock gets sold for $58/share or in the event of a price drop to say $56, we continue to hold the XLE ETF to resell the option for some future time.

Assuming we get called out, we would recoup $34,800 plus we get to keep the $840. Our profit % is = $840/$34,800 = 2.4% (does not include commission). So in less than 30 days, we made 2.4% profit. Imagine if we could repeat this every month! 2.4% x 12 = 28.97% profit gains!

Could we have done any better? You bet!

Suppose that instead of selling the Sept ’06 option, we decided to look a year out.

xle_7_07_option.gif

We look at Jun 07 and see that the $58 option is trading at $6.90. So if we had sold the Jun 07 option, we would have made 600 x $6.90 = $4,140. Our profit would be 11.90% for the future year CAPTURED TODAY!

Did you catch the best part here? If we made our transaction in August, we RECEIVE the cash benefit ($4,140) the day we made the trade. That’s $4,140 in your pocket today!
The downside (if you want to call it that) is that you now have to wait until June 2007 to see if you’ll get called away. If you do get called away, you’ve unloaded the ETF and pocketed your profit. If you don’t, you hold on to it and resell some future options.

Of course, the first thing the nay-sayers (and mutual fund lovers) out there will say is “well, what happens if energy (oil) goes down and XLE drops from $58 to $40/share?”

My response is what happens if your energy mutual fund drops from $58 to $40/share? Did you make $4140 during that drop? Did you pocket 11.9% profit? What happened to that buy and hold mutual fund philosophy?

Then the other thing the nay-sayers say is “Well, what happens if XLE goes to $100/share? You lost out big on that one (with a smug look on their face)!”

My response is, “congrats, I missed out on that one, I got called away at $58 and only made 11.9% profit and pocketed $4140 a year ago in my portfolio; I’m happy with that but I’m sure that your mutual fund manager is ecstatic – he makes 2% off of your growing investment!”

If I can consistently make 12% return on $40,000 then in 20 years I will have $435,702. If however, the stock market makes an average return of 10% then that’s a difference of $142,579! Worse yet is if mutual funds only return 8% (after fees) then you’re looking at a loss of $238,629!

Tomorrow, in Part IV, I’ll share the easy way of finding the right ETF for great returns and some things you can do to mitigate the downtrends in ETFs.