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Trading covered calls in equity market index ETFs presents investors with a broad range of possibilities, some upsides, and some downsides.

Unlike mutual funds, ETFs are traded on exchanges and typically have option contracts at multiple strike prices trading with some volume each day. This gives the investor, or speculator, an additional tool that you would not have with a traditional mutual fund. Investors can buy and sell put options and call options for speculation or income.

The upside to selling covered calls is that this strategy can be employed in a tax-free retirement account (by knowledgeable investors) and can be used with a diversified basket of stocks through the ETF. One of the usual drawbacks with a traditional covered call transaction, on a typical common stock trade, is that bad news could wipe out a large percentage of the investment, just as if you owned the stock outright. When trading covered calls on an ETF, your risk of massive losses is reduced drastically through diversification.

The downside of utilizing a covered call strategy with an ETF is that your total potential returns will likely be lower due to less volatility in the funds.

The iShares MSCI EAFE Index (EFA) ETF is an equity market indexed ETF that tracks the performance of developed markets outside of the U.S. & Canada. The index holds stocks such as GlaxoSmithKline PLC (GSK), Toyota Motor Corp. (TM), and Vodafone Group PLC (VOD). The index is currently trading close to the 50-day moving average.

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A typical covered call trade in this index would involve buying at least one 100 share lot of stock and selling at least 1 call option against those shares. Using a calculator provided by the Options Industry Council, we can compute a typical return on investment for a trade like this.

Shares are currently selling for $49.15. The August $50 strike price call option is priced with an option premium of $0.94. Selling this call could potentially lock in a selling price of $50.94 on shares purchased for $49.15, if the price rises above $50 by the option expiration on August 17, 2012. After commissions, the profit could potentially be about 3.6%, or 34.16% annualized. If shares trade flat, the $0.94 option premium becomes income to the investor and represents a yield of 1.5% over the next 38 day holding period, an annualized 14.5% yield. If shares fall, the break-even price for the trade is $48.26.

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A similar strategy could be employed with the iShares MSCI Emerging Markets Index (EEM). This index owns companies like Samsung Electronics Co Ltd (OTC:SSNLF) and China Mobile Limited (CHL).

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Buy the ETF at $38.20 and sell the August 18, 2012 $39 strike price call for $0.86. If shares trade above $39 at the expiration date, you lock-in a sales price equivalent to $39.86 on shares purchased for $38.20. The annualized return for being called is about 36.84%. If shares trade flat, you collect the option premium of $0.86, or about 1.8% over 38 days. That's an annualized yield of 16.7%. The break-even price on the trade is $37.54.

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There are many more options trades with higher return potentials. However, while these returns are nothing to get overly excited about, consistently generating this type of income could be a game changer for any portfolio.

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

Source: Trading Covered Calls In Large Equity ETFs