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Using covered call writing and exchange-traded funds (ETFs) is a viable approach to generating monthly cash flow. I personally use this strategy in my mother’s portfolio. Can this investment style be expanded to include inverse ETFs to move this expanded path to a near risk-free system?

In April 2017, Rushbabh, a member from Australia, was kind enough to share an idea he developed involving ETF and inverse ETF index trackers combined with covered call writing.

 

The hypothesis

  • Buy an index tracker ETF
  • Buy an inverse index tracker ETF
  • Sell covered calls on both securities
  • Collect premiums and liquidate both ETFs if options are exercised

The question Rushbabh posed to me asked if I thought this could be a risk-free investment.

 

The scope of risk: no free lunches!

If our goal is to exceed risk-free returns (Treasuries for example), we must incur some risk. As investors, we must locate and define our comfort level as to how much risk we are willing to expose ourselves to and determine the return goals we are seeking. If Treasuries are at one end of the spectrum and buying lottery tickets is at the other end, then covered call writing is somewhere in between the two and closer to Treasuries in my view. Of course, this assumes mastering the three required skills (stock selection, option selection and position management).

 

Evaluating proposed strategies by paper-trading

The best way to examine an investment concept is to set up trading guidelines and paper-trading over a meaningful time frame. To me, this is a more relevant and practical procedure than having a computer do the work for us. We can tweak the trading guidelines and find nuances to enhance positive steps and delete the negative ones. In this article, I created a spreadsheet for an initial non-scientific study which incorporated the following hypothetical parameters:

  • ETF index tracker is trading at $50.00
  • ETF inverse index tracker is trading at $50.00
  • $50.00 call option strike prices were $2.00 for both securities
  • Initial per share total premium collected totaled $4.00 for each “set” of ETF positions
  • ETFs will move in opposite directions by equal amounts

 

Spreadsheet reflecting returns for various price changes

covered call writing strategies

Covered Call Writing ETFs and Inverse ETFs

Note the following:

  • For each “combined position” we have a net options credit of $4.00 per share. 100 shares of ETF + 100 shares of inverse ETF will net $400.00 (less commissions)
  • The price of the securities will move in opposite directions by an equal amount based on the movement of the underlying benchmark
  • The upside is capped due to the option obligation
  • The downside is not capped but subject to position management opportunities
  • The cost-to-close for each security also moves in opposite directions
  • Our breakeven is $4.00 from the initial cost basis and strike, $54.00 or $46.00 in this hypothetical
  • Once either security moves more than $4.00 from the initial strike price, we start to lose money

 

Conclusion

The takeaway from this (admittedly) non-scientific study is a guideline we have applied to covered call writing for years…once underlying (combined in this case) share price moves below the breakeven, we start to incur loses. Until a longer-term analysis can be examined, it initially appears that this is a strategy that will have positive results when there is little price movement in the underlying securities. The term “risk-free” is not appropriate.

 

Discussion

In our stock market environment, there are no risk-free trades. There is certainly nothing wrong with looking to develop new strategies that will minimize risk and I commend Rushabh for thinking outside the box. I admire members who seek to achieve even higher returns using their education and trading skills.

 

Next live events

  • All Stars of Options (just added)

October 4, 2017

10:00 AM – 10:45 AM

Hyatt Regency Dallas @ Reunion

  • Dallas Texas: October 5, 2017
  • Money Expo: An online webinar event: Monday October 9, 20173 PM ET: Online event hosted by The Money Show. Alan will be a featured speaker at MoneyExpo, which is the biggest online-only premier event for traders and investors across all traditional asset classes. Registration link and information to follow.

Palm Beach Gardens Florida: October 10, 2017: 

 

Using options to generate monthly cash and to buy a stock at a discount.

LOCATION: Publix Greenwise Market (2nd floor)

11231 Legacy Avenue (Legacy Place)

Palm Beach Gardens, FL 33410

The club charges $10 at door to cover expenses.

 

Market tone

Global stocks edged up this week despite some midweek volatility resulting from North Korea’s missile launch over northern Japan. West Texas Intermediate crude oil dropped 80 cents a barrel to $46.75. Volatility, as measured by the Chicago Board Options Exchange Volatility Index (VIX), ended the week lower, at 10.13 from 11.9 a week ago. This week’s economic and international news of importance:

  • US nonfarm payrolls rose a less-than-expected 156,000, missing estimates for a 180,000 rise
  • The unemployment rate ticked up to 4.4% from July’s 4.3%
  • Payrolls for the prior two months were revised lower by a combined 41,000
  • The August Institute for Supply Management manufacturing index reached a six-year high of 58.8, up from 56.3 in July. Manufacturing data across the developed world were on the firm side, suggesting the synchronized global economic upturn remains intact
  • An estimated 23% of US refinery capacity is offline because of flooding in the wake of Hurricane Harvey
  • Nationally, gasoline prices have risen an average of 17 cents a gallon since Harvey made landfall and now average $2.45, according to AAA
  • North Korea conducted several missile tests this week in response to annual US-South Korea military exercises. The second launch crossed over Hokkaido, Japan’s northern island
  • The US economy grew at a 3% annual pace in the second quarter, an upward revision from the 2.6% pace reported in July
  • Spending was robust by both consumers and businesses in Q2, with capital expenditures expanding at an 8.8% rate — the fastest in nearly two years
  • Corporate profits rose 8.1% year over year
  • President Donald Trump travelled to Missouri this week to make the case for overhauling the US tax code. But, the president offered few specific policy
  • The third and latest round of Brexit negotiations ended with no agreement on key issues such as the Northern Ireland border, citizen’s rights and the size of the Brexit divorce payment

THE WEEK AHEAD

Mon, Sep 4th

  • US markets closed for Labor day

Tue, Sep 5th

  • Australia reserve bank interest rate decision
  • Global purchasing manager’s indices
  • Eurozone Q2 GDP and retail sales
  • Eurozone sentiment index

Wed, Sep 6th

  • Non-manufacturing PMI
  • Fed Beige Book

Thu, Sep 7th

  • Eurozone interest rate decision

Fri, Sept 8th

  • Japan Q2 GDP
  • China trade balance
  • UK industrial production
  • Canada unemployment rate

For the week, the S&P 500 moved up by 1.40% for a year-to-date return of 10.13%

Summary 

IBD: Market in confirmed uptrend

GMI: 6/6- Buy signal since market close of August 31, 2017

BCI: I am currently favoring in-the-money strikes 2-to-1.

 

WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US

The 6-month charts point to a cautiously bullish outlook. In the past six months, the S&P 500 was up 3% while the VIX (10.13) moved down by 20%.

Our thoughts and prayers are with all our friends who have been impacted by Hurricane Harvey.

Much success to all,

Alan and the BCI team

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