How to Trade Covered Calls With ETFs | ETF Trends

The beauty of exchange traded funds (ETFs) is the ease with which they can be used by both newbie investors and old hands. Take covered calls, for example.

Covered calls are an options strategy in which an investor holds a long position in an asset, then sells call options on the same asset in order to generate increased income.

Why would you do it? Investopedia notes that it’s often done when an investor has a short-term neutral view on the asset, and the strategy is also known as “buy-write.” 888Options also states that this would be used when an investor feels that a fund’s market value will see little range over the lifetime of the call contract.

One ETF that employs such a strategy is the PowerShares S&P 500 BuyWrite (PBP), which is down 11% year-to-date.

But if you want to use the buy-write strategy with other ETFs, Larry Connors for Trading Markets explains how you can. Please note that this example is purely hypothetical, and these are not recommendations.

If you’re bullish on financials, you might want the Ultra Financials ProShares (UYG), which is designed to give twice the daily performance of the Dow Jones U.S. Financials Index. Connors notes that the fund is a diversified mix of bank, brokerage, insurance and real estate stocks, and unless all those industries are nationalized, it’s next to unlikely that UYG would go to zero.

On Friday, UYG closed at $2.20, and June 3 calls were selling for 50 cents. This means that you could by UYG at $2.20 and take in more than 20% of premium for a less than four month call.

If the fund climbs above $3 by June, the return to call is $1.30 – a better than 50% return after costs. The annualized return is 150%.

If UYG is under $3 by that date, you will get the chance to sell the out the money (OTM) calls again, maybe at another premium.

The risk in this strategy is that the fund’s price could decline, however, giving the investor a substantial loss.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.