The financial talking heads and pundits have been saying for some time now that the stock market is destined to take another nosedive in the near future. Time will tell whether their short-term predictions are correct or not, but the stock market is cyclical, so there will always be ups and downs, which causes problems for investors using the covered call investing strategy.
One of the most common complaints against the covered call investing strategy is the exposure when stock markets make severe downward movements. However, investors can circumvent the problems with covered calls in a bear market by entering covered calls against short and ultra short Exchange Traded Funds (ETFs).
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Inverse or short ETFs are traded on exchanges like stocks and are designed to perform opposite or inverse to the long version of the ETF. Short ETFs operate by selling stocks short and trading derivatives such as futures contracts.
One downside to short and ultra short ETFs is the increased expense ratio compared to other ETFs. The SPDR S&P 500 ETF (SPY) for example has a net expense ration of 0.095% whereas the ProShares UltraShort Real Estate ETF (SRS) has a net expense ratio of 0.95% – a 10x difference. In real dollars, $10,000 for example, the expense ratio for the SPY ETF represents $9.50 per year versus $95.00 per year for the SRS ETF.
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Option investors might simply consider the $95.00 as a cost of doing business when the weather forecast for the stock market is bleak. When the stock market bears are roaring, maybe its worth it to pay more for the higher cost of the lemons required for making lemonade.
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In October of 2008, the outlook for the stock market was very bleak and entering covered call investing positions for stocks of any type or entering a long position was not an attractive investment strategy. However entering covered calls for a short or inverse position was attractive.
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On 10/20/2008, the Palladium newsletter published a covered calls trade for the ProShares Ultra Short Real Estate ETF (SRS). To enter the position, SRS was purchased for $131.01 and a call option (SRSKC) was sold for $25.6. The call option had November expiration and a strike price of $120. The SRS covered calls trade had a potential return of 13.8% and downside protection of 19.5%.
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The stock market recovered somewhat after entry, but then continued its decline. The real estate sector also recovered after entry of the position and then continued its decline. Even with the retrace in the price of SRS, the covered calls for SRS remained in the profitable region and at November stock options expiration on 11/21/2008 the price of SRS was $216.67. The SRS ETF was subsequently called away and a profit of 13.8% was made on the position.
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A graph of the SRS ETF over the time period for holding the covered calls trade is shown below:
As can be seen, the price movement of SRS moved counter or opposite the movement of S&P 500 ETF (SPY).
A long position in SRS would have resulted in a whopping return of 65% over the time period, however on 11/4/2008 the price of SRS was at $110.00 representing a loss of -16%.
Even though the covered calls trade generated less return, it also presented less pain as the covered calls position was in the profitable region during the entire time while a long position in SRS would have been in the red for several days after entering the position.
For more information about how to identify and research great option trades, visit the PowerOptions website. There you will find the data you need to make quick, clear, and informed decisions. You can trade knowing you have found the best investment. Also, PowerOptions will allow you, with a few quick clicks, to quickly and accurately compare trades. PowerOptions’ premium customer support is second to none in the industry. They can be easily contacted when you need them at their toll-free number to answer customer questions. Call them now toll free at 877-992-7971.
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[tags] ETF, derivatives, futures contracts, ultra short ETF, Palladium, newsletter, SRS, ProShares UltraShort Real Estate ETF, SPY, S&P Depositary Receipts Trust ETF [/tags]