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Exchange-traded funds can be outstanding securities to employ in our covered call writing portfolios. Let's explore how they operate and evaluate the pros and cons of utilizing them in our investment strategies.

When we buy one share of the Qs (Powershares Exchange-Traded Fund Trust – Powershares Qqq Trust, (NASDAQ:QQQ) for $55, we are purchasing a piece of all 100 shares in the fund. So how does that work? Are we applying $0.50 towards each stock? It’s actually a bit more complicated than that.

The Mechanics of an ETF:

These funds are continuously creating new shares or redeeming existing shares depending on market demand. The shares represent ownership interest in the underlying basket of securities. Only large institutional investors called Authorized Participants (APs) partake in this creation and redemption process. They will buy creation units or sell redemption units over sophisticated electronic platforms. Shares are created when the APs provide a basket of securities to the fund which then creates ETF shares that are handed over to the AP. These ETF shares are then sold on the secondary market (exchanges) to us by the APs.

On the other hand, when an AP provides the fund with a number of ETF shares (redemption unit), they will receive from the fund the associated basket of securities.

What’s in it for the APs?

Are they doing this to be nice guys and allow BCIs to take advantage of these funds? I don’t think so either! They are doing it to take advantage of arbitrage opportunities. These are simultaneous purchases and sales of assets in order to profit from a difference in the prices. Here’s how the game is played:

The underlying securities in an ETF are priced every 15 seconds during the trading day. This value is similar to the NAV (net asset value) of a mutual fund which is priced only after market close. When there is a small difference between the intraday NAV and the actual share price of the fund, the AP can buy one and sell the other to generate a profit. This arbitrage process actually serves a useful function for us in that it keeps the fund price and the NAV price very close.

ETF Pros:

  • Diversification
  • Lower annual taxable distributions
  • Lower costs
  • Lower management fees
  • No 12-b-1 fees (marketing and distribution costs)
  • Trading flexibility:
  1. can be purchased on margin
  2. can be bought and sold @ intraday market prices
  3. can be traded with stop and limit
  4. can be sold short

ETF Cons:

  • Subject to market risk like investor sentiment and global conditions
  • Market pricing discrepancies (between NAV and actual share value) particularly in less liquid funds
  • Tracking discrepancies- returns may be more or less than the benchmark for the following reasons:
  1. A fund may sample the benchmark rather than duplicate it exactly
  2. Dividend distributions from a fund may differ from the equities themselves
  3. The expense ratio (administrative costs) reduces profits
  4. Regulations require no one company represent more than 25% of the fund. This may not represent the actual fund allocation.

ETFs and covered call writing:

The conservative approach would be to get the most diversification so that out-of-favor securities can be mitigated by the others. Usually the greater the diversification, the lower the premiums because of lessened volatility. But this seems to suit the needs of conservative investors.

Two popular ETFs with tremendous diversification are:

  • VTI - Total Stock Market
  • SPY - S&P 500

For greater premiums but also greater volatility:

  • QQQ - Nasdaq 100
  • IWM - Small Cap

Other popular ETFs:

  • DIA - Dow 30
  • MDY - Mid-Cap 400

I have been using the Qs in my mother’s account for years with excellent success. For the most conservative approach, look @ VTI and SPX and expect a return of 1-2% per month in normal market conditions. Another approach would be to utilize the top performing ETFs and update your portfolios on a regular basis so you are always dealing with ETFs favored by the institutional investors. This information is provided weekly to our premium members.

Conclusion:

ETFs are vehicles that can benefit both institutional and retail investors. For writers of covered calls, the main asset is its instant diversification that permits a conservative approach to an already conservative strategy.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Exchange Traded Funds And Covered Call Writing