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Covered Calls and ETFs: A Combination Worth Writing Home About

|Includes: VanEck Vectors Coal ETF (KOL)
Many investors are familiar with the advantages of using covered calls to bolster the returns on the stocks and hedge a portfolio against downside risk all while generating some income. But did you know that covered calls can be applied to ETFs in the same they're applied to equities with some very potent results? This makes sense. After all, ETFs trade just like stocks and many of the most popular ETFs are those that track equities, so it stands to reason that a properly employed covered call strategy can generate some nifty returns with ETFs.

The strategy of using covered calls with ETFs is the same as with individual stocks and the benefits remain the same, too. You'll get downside protection, capital appreciation if your ETF rises in value, dividends from the stocks your ETF holds and earn income on the covered calls you write. One tip to consider is the following: Try to find options contracts to sell that have decent liquidity. I like to shoot for open interest in the neighborhood of 500 contracts. At a bare minimum, I look for 200 contracts, just to ensure the liquidity in that strike is good enough so I can my desired fill.

Writing covered calls on ETFs isn't complex or scary. As I said, it's comparable to writing covered calls on stocks. That means the worst case scenario is you get your ETF called away from you if it rises in value beyond the covered call's strike price. If the ETF you've written covered calls on trades down or sideways, you keep your ETF and the income you received when the covered calls you've written expire and perhaps earn some dividends along the way.

Of course, the generated income is the primary advantage when it comes to writing covered calls and this income helps you establish predictable returns. Say you buy 100 shares of an ETF for $25 per share, and you sell a covered call with a one-year expiration date, at a strike price of $28, for $2. Your rate of return is 8%, guaranteed; you’ve already received the money. Here's a mythical chart example that outlines the risk/reward of covered calls that are out-of-the-money.

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In my humble opinion, there are two ways to approach covered calls and ETFs. An investor can accumulate enough shares in an ETF as to where writing calls that are deep out of the money generates enough income to make it worth the effort. I'd put this strategy in the more conservative camp. For the more adventurous among us, this is what I like to do:

Identify a high-beta ETF such as a liquid equity-based oil ETF or something like the Market Vectors Coal ETF (NYSE: KOL) and just go one month out and write calls that are just $2-$4 out of the money. Using a real world example, if you got into KOL in the $45-$46 area, you could sell the July 48 calls for 50 cents per contract as of Tuesday close. Call it $2.50 per share in capital appreciation if KOL goes to $48 and $50 per contract and you've got a nice little pay day assuming KOL was a trade, not an investment for you.

Bottom line: Don't ignore the potency of covered calls for your ETF holdings.


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