I’m going to go through some of the mechanics here of writing a covered call on an ETF for a reader with some questions.

First thing you need to do is own or purchase an ETF that trades options. I’m using SMH (Semiconductors) ETF as an example.

When trading options remember that 100 shares = 1 contract. If you want to sell contracts you need to have at least 100 shares and round lots of 100 only. There are no “half-contracts” you can sell with 50 shares or other weird denominations. There are special circumstances when a stock splits or gets merged with another company but those are usually listed as “special” or “NS – Non Standard” and your best bet is to avoid trading any of those. Options EXPIRE EVERY THIRD FRIDAY OF THE MONTH. Most ETFs don’t trade options EVERY SINGLE MONTH so plan your trades accordingly.
Click on the image to follow along.

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I bought 1000 shares of SMH; this means I can sell 10 Call Options on my stock. This will give someone else the right to buy my stock at a pre-determined price. What price can they buy my stock from me at? That depends on what Call Strike Price I selected when I sold the Calls.

If you look at the image, you can see the STRIKE column on the far left of the table. Listed below are amounts such as 20, 25, 30, 35, 37.50. Each of those STRIKE prices has a SYMBOL associated with it such as

  • SMHAD = 20
  • SMHAE = 25
  • SMHAG = 35

I bought SMH for $34.25/share. If I bought in at $34.25 it doesn’t make sense to sell Calls for anything less than what I bought the stock or I’ll lose money. That means the only strike prices I could sell were for $35, $37.50, or $40. You’ll see that as you go up in strike price, the less money people are willing to pay.
If I had sold my Calls OUT-OF-MONEY at $37.50 (SMHAU) I would only receive $0.05 for each contract so I would have received $0.05 x 10 (contracts) x 100 (shares) = $50.00. This amount of money wouldn’t be worth the trouble.

If I sold calls IN-THE-MONEY at $35 (SMHAG), I would receive $0.25 for each contract so I would have received $0.25 x 10 x 100 = $250. Much better!

Back in early December, option traders were willing to pay me $0.85 per contract so I made 10 (contracts) x 100 (shares) x $0.85 = $850.00. Today, they’re only willing to pay $0.25 so I could buy back my own contracts at $0.25 and keep the difference! Sold $0.85 and buy back at $0.25 = $0.60 profit per contract ($600). Should I buy them back or should I hold out for $35?

If I wait and SMH hits $35, I’ll make and additional $0.75/share because I bought in at $34.25 and will be forced to sell at $35.00. That translates into another $750 in profit! Wait or Cover?
Now, what happens if you bought at $34.25, Sold $35 contracts but the ETF went down to $30.00?

In this scenario, your contracts will likely end up being worth $0.05 or less because who would want to buy the right to buy your stock from you at $35 when they can just go and buy it outright on the open market for $30?
What do you do if SMH is now stuck at $30 and want to sell more calls?

You have some options (pun intended). The further you go out into the future on a calendar, the higher the premium paid for the calls. If you click this link http://finance.yahoo.com/q/op?s=SMH&m=2009-01

You will see that January 2009 $35 call strike options are selling for $5.50. Wow that sounds pretty cool $5.50 x 10 x 100 = $5500 I could pocket right now!

But the problem is Time Value of Money. If you pocket the $5500 now you’re earning 16% return on your investment. Sounds great EXCEPT you have committed your money & stock for the next TWO years until January 2009 and if two years from now the ETF is trading at $75 you are probably going to be kicking yourself because you’ve committed to selling your stock at $35.00 in exchange for receiving $5500 today. Those January 2009 options could be selling for $30/each if SMH shoots up to $75.00 in January 2009. If you’re happy with 8% return annually then by all means sell the January 2009 $35 strike price but remember that a lot can happen in two years!

So what you need to do is figure out what ROI is most desirable to you. If SMH dropped to $30 I wouldn’t want to risk losing my shares by selling $32.50 Calls because I paid $34.25 for them! If I owned SMH for 12 months and each month I’ve made $1000 in profit then I may be willing to do so if I’m interested in liquidating my position or have made enough profit on this ETF where losing a few hundred dollars wouldn’t really hurt my portfolio if I got called.

Mutual Fund fans always talk about Dollar Cost Averaging your shares. Well by selling covered calls, you’re effectively dollar cost averaging your shares except you get to see (and use) the cash in your account. I bought SMH at $34.25 and sold contracts for $0.85, my new break even point on SMH is $33.40 sans commissions.

So what you need to do is look for the HIGHEST YIELD with the SHORTEST TIME PERIOD so that you can repeat the process over and over again. I look for returns of 3% to 6% within a 30 to 60 day window on ETFs. I publish my findings every Friday over at http://www.etfcoveredcalls.com.

I’ll follow up in two weeks on January 19th when Options Expire to further illustrate what happens. SMH may be above $35 to say $36.30 in which case I’ll be forced to sell at $35.00 and lose my stock or SMH may be below $35 to say $33 in which case I’ll keep my shares and look at February, May or August $35 strikes for some more call writing.