From Wikipedia: In colloquial usage, a fractal is “a rough or fragmented geometric shape that can be subdivided in parts, each of which is (at least approximately) a reduced/size copy of the whole.”

See the pattern?

About a year ago, I took the kids to the zoo and we came across a magnificent tree. It was a tree about 30 feet tall with branches expanding at almost equidistant levels throughout the tree. Upon closer examination the tree clearly followed the Fibonacci sequence as its branches expanded out from 1, 1, 2, 3, 5 and on. One trunk expanded to one branch, one branch expanded into two subbranches and those branched out into small branches. It was beautiful butI didn’t have my camera so I don’t have a photo of it but you can see the pattern in the flower below.
See the pattern?

This brings me to ETFs. ETFs are derivatives, they derive their value from their underlying stocks. These stocks (some but not all) have options that are traded on them as well. The options are derivatives of these stocks. Writing covered calls on an ETF is essentially writing a derivative instrument on a derivative instrument. See the pattern?

I have a primitive graphic to help illustrate a component of ETF Covered Calls and how it pertains to derivatives of derivatives of SMH.

SMH_Comp1.png

SMH is composed of many stocks. Three stocks however represent 52% of the holding (the big branch ;) ) and the remaining stocks represent smaller and smaller amounts (smaller and smaller branches). When examining the main three stocks and looking at their options for January 2008, you can see a fairly robust return of about 17% for in/near the money calls for these stocks.

My crappy graphic is no comparison to mother nature but if you can use your imagination a bit you might begin to see the pattern. I don’t know what methodology ETF creators/designers use when creating indexes and I’m not sure if the fractal & Fibonacci patterns are by design or randomly occur because of human (mother) nature but it’s always interesting to see the patterns form.

Why did I pick January 2008? Because one of my goals is to earn 20% per year and picking the right ETF(s) means looking a year ahead. I created this post because a reader asked how I went about picking my ETFs for covered calls. I have many different components including using a custom built ETF-Cashinator application and observing patterns & trends (not technical charts).

In this particular instance, a strong trunk (SMH) leads to strong branches (TXN, INTC, AMAT) which lead to strong sub-branches (Options) which come back to make a beautiful tree (Covered Calls on SMH).