Covered Call Writing With Select Sector SPDRs

|
 |  Includes: XLB, XLE, XLF, XLI, XLK, XLP, XLU, XLV, XLY
by: Alan Ellman

Select Sector SPDRs are unique exchange-traded funds that divide the S&P 500 into nine sector index funds. They have the diversity of a mutual fund, the focus of a sector fund, and the tradability of a stock. Together, the nine Select Sector SPDRs represent the S&P 500 as a whole. However, each Select Sector SPDR can also be bought individually, providing you with exposure to a particular sector or industry group.

These securities all have options and can be used with our covered call strategy. Each week the BCI Team will do a 3-month technical analysis of the linear price chart of each sector and compare it to the performance of the S&P itself. The top 3 funds outperforming the market benchmark will be listed and considered to be among the best candidates for covered call writing in the near-term. We will also show a chart of all sector components (located in our premium site).

The nine Select Sector funds are:

The Consumer Discretionary Select Sector SPDR Fund - XLY
The Consumer Staples Select Sector SPDR Fund - XLP
The Energy Select Sector SPDR Fund - XLE
The Financial Select Sector SPDR Fund - XLF
The Health Care Select Sector SPDR Fund - XLV
The Industrial Select Sector SPDR Fund - XLI
The Materials Select Sector SPDR Fund - XLB
The Technology Select Sector SPDR Fund - XLK
The Utilities Select Sector SPDR Fund - XLU

Exchange-traded funds are securities that track an index or a basket of assets like an index fund, but trade like a stock. They provide the diversification of an index fund. Many ETFs have options associated with them and are therefore covered call candidates.

Disadvantages of using ETFs: The one glaring disadvantage is the lower return generated by using these funds as the underlying security rather than individual securities. Expect returns between 1 1/2% and 2% (per month) rather than 2-4%, which is our goal with individual equities in normal market conditions. This is a result of the fact that we are using a basket of stocks which reduces the overall volatility of the underlying, making the option premium less valuable. For this reason, I prefer individual equities but will use these ETFs in certain situations (earnings season and my mother's more conservative portfolio, for example). These are also appropriate for ultra-conservative investors and during extreme market volatility.

Advantages of using ETFs

  • Instant diversification
  • No concern about earnings reports or same store monthly retail sales reports
  • Requires less of an original investment
  • Less management needed

How to select ETFs for your Covered Call Portfolio

Since we are dealing with a basket of stocks, fundamental analysis becomes less of a requirement. So I come back to what I consider the most critical factor to consider: What are the institutional investors doing regarding this security? To resolve this issue, I compare a 3-month chart of the S&P 500 ("the market") to various selected ETFs. The BCI team screens hundreds of ETFs each week and publishes the top-performers on our premium site. In this article, we will focus on the Select Sector SPDRs. Here is a sample bar chart which displays all 9 Select Sector SPDRs:

Click to enlarge

At the date of publication of the report, we chart the top-three performers and compare it to the market benchmark. Here is one such chart:

Click to enlarge

Top-three Select Sector SPDRs:

  1. XLE- $72
  2. XLF- $15.50
  3. XLK- $31

Next, let's assume a portfolio with cash available of $50k. We will set aside 2%-4% for possible future exit strategy execution. That leaves 3 securities and $48k to spend. We will give equal cash allocation of approximately $16k per security as we round off to the nearest 100 (we need 100 shares per contract). Let's calculate:

Cash Allocation

Since we spent $45,500, we will have a cash balance of $4,500 from our original $50k for possible exit strategy execution. This is a bit more than we need so additional shares of XLF or XLK may be purchased.

Next, access the option chains and enter the stats into the Ellman Calculator:

Click to enlarge

Ellman Calculator

The 1-month initial return is about 2% for a 6-WEEK RETURN or 17.5% annualized.

The cash generated per contract (not including small commissions) is as follows:

  • XLE: 2 x $210 = $420
  • XLF: 10 x $21 = $210
  • XLY: 5 x $58 = $290

The total cash generated is $920.

The percentage initial return is $920/$45,500 = 2.02%.

You will note that I used near-the-money strikes which generate the highest initial returns. Based on your market assessment, you can take a more or less aggressive stance.

Conclusion

The use of ETFs in our covered call portfolios has its advantages and disadvantages. Understanding these pros and cons will help us determine how and when to utilize these securities.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.