Yeah, I know I keep harping on how great ETFs are, but they are a fantastic innovation for investors. I’m not saying mutual funds are bad, though. A great actively managed fund can provide you with safety and superior returns.
ETFs, however, have two big advantages. First, they trade instantaneously on the market, so you can move in and out as you please. Mutual funds require you to wait until the day’s closing price to get an execution.
The other big advantage is that you can trade puts and calls on ETFs. That means you can augment or hedge your position simultaneously. You can theoretically do much the same thing with mutual funds by trading puts and calls on ETFs that are substantially similar. The problem is that if you get an ETF called away, you will have to purchase it since you own the mutual fund version.
I suggested three sectors to buy for 2015, so let’s look at some puts and calls with those.
3 Ways to Trade Puts and Calls on ETFs: Vanguard Consumer Discretionary ETF (VCR)
The first sector I suggested was consumer discretionary, as represented by Rydex S&P Equal Weight Consumer Discretionary ETF (NYSEARCA:RCD). This ETF doesn’t have options, but a very similar ETF does -– the Vanguard Consumer Discretionary ETF (NYSEARCA:VCR).
Maybe you are worried about the market but like the discretionary idea. So sell some naked puts. The VCR trades at $115.30. You can sell the Mar $115 put for $2.90, which earns you a 2.53% return for a 53-day holding period, or 17.6% annualized. That’s a really great annualized yield for a sector that probably wouldn’t return that much during the year.
Whether the VCR ETF gets put to you or not, you can sell another set of puts after these expire, and continue that process throughout the year. If the ETF falls, you are effectively averaging down. If it rises, you are collecting income along the way while never committing to owning the ETF.
3 Ways to Trade Puts and Calls on ETFs: Technology Select Sector SPDR ETF (XLK)
I also suggested that tech might do well, in the form of Rydex Equal Weight Technology (ETF) (NYSEARCA:RYT), but that doesn’t trade puts and calls. Few of the other real technology ETFs do, either. It’s frustrating because in this case, the others are technology-related and carry the big, familiar names like Apple Inc. (NASDAQ:AAPL) but not hard-core tech names. Or they are way too narrow, like only holding semiconductors.
Still, you could do worse. So go with the Technology Select Sector SPDR ETF (NYSEARCA:XLK). It trades at $41.28. The Mar $41 put sells for 90 cents, which is just about a 2% return, or 14% annualized.
You could also choose to buy the underlying XLK ETF itself and sell a covered call against it. The Mar $42 call is selling for 61 cents, which is about a 1.5% return on the strike price, plus another 72 cents on the capital gain if called away, or 3.22% total. That’s a 22.5% annualized return, which is something closer to what I’d expect if tech really does well this year.
3 Ways to Trade Puts and Calls on ETFs: iShares Dow Jones Transportation Average (IYT)
My final selection are the transports, which I like in the form of the iShares Dow Jones Transportation Average (ETF) (NYSEARCA:IYT). If you hold it already, as I do, then you’ve been happy with the airlines that have reported earnings, but a bit bummed at the United Parcel Service, Inc. (-itynnn) fumble.
That’s why you own ETFs! For the diversification!
The IYT trades at $162.14. You can go with puts and calls here if you like. The Mar $165 call is selling for $3.30. I love that even this far out of the money, you can get a 2% return, or 14% annualized just on the option alone. If it got called away, add in the $2.86 in capital gains for a total return of 3.8%, or 26.6% annualized.
On the IYT puts, you can sell the Mar $162 put for $5.10. That’s a 3.15% return, or 22% annualized.
As of this writing, Lawrence Meyers held shares of IYT and AAPL.