I usually write about covered calls or naked puts in relation to individual stocks. This is where I usually find the most generous premiums which I use to augment my income-generating securities.
However, sometimes it pays to use covered calls in relation to major indices (or the exchange-traded funds that track them). This strategy is not only useful as far as generating income, but I like it because it can act as both a hedge and as a play that has little risk.
The stock market has a long-term positive bias. That is, the stock market goes up over time. Thus, if you sell covered calls repeatedly against an index, the chances are the underlying security is eventually going to get called away. You collect the premium as your reward.
However, if you feel the market is overvalued as I do, then you can hedge against any index ETFs you may hold by selling covered calls against it.
Here are three ideas to generate income from the market.
Covered Calls on the SPDR S&P 500 ETF Trust (SPY)
Let’s take a look at the base model index, the S&P 500 as represented by the SPDR S&P 500 ETF (SPY). The 52-week range of SPY has been from $182 to $213.78, with Monday’s close at $207.
The market has been range-bound, I believe, because investors are getting antsy about the price of many of these blue-chip stocks in the SPY. However, when dealing with covered calls, we love range-bound securities. While the premiums aren’t gigantic, it means we may be able to sell covered calls repeatedly and generate some solid income while also hedging our position.
There are many choices here, but I’m going to assume we get a December rally as we often do, and suggest selling the Dec $207 covered calls for $4.34. That’s a 2.1% return for a 54-day holding period, or 13.6% annualized.
Covered Calls on the PowerShares QQQ Trust, Series 1 ETF (QQQ)
If you are looking for something more volatile, then have a look at the PowerShares QQQ Trust (QQQ), which represents the Nasdaq-100 index, consisting mostly of technology shares.
Whereas the 52-week range of SPY was 15%, the range for QQQ is much larger at almost 30%. In fact, it has soared off its low of around $85 back up to $112.85 as of Monday’s close, just a hair off its high of $114.39.
Because we are only halfway through earnings season, there are many more reports to come, so this is a good time to sell some covered calls against QQQ if you are feeling like things might be headed lower, but you want to pick up some income while riding out any possible decline.
Here you may want to consider selling the weekly Dec 4 $113 covered calls for $2.24. This gives you a 2% return for only a 40-day holding period, or a roughly 18% annualized return.
Covered Calls on the iShares Russell Midcap Index Fund (ETF) (IWR)
If you’d like something right in the middle, then think about selling covered calls against the iShares Russell Mid-Cap ETF (IWR). Mid-cap stocks are great because they offer a good degree of volatility but without the risk of being small, undiscovered stocks.
The IWR has seen its share of volatility in the past 52 weeks. It has ranged from a low of $138.61 to a high of $176.48. That’s a 25% range, and that means there’s some good volatility to mine. Monday saw a close at $164.31.
You have two interesting plays here. The first is to sell the Nov $165 covered calls for $1.95. This nets you a modest 1.2% return for a mere 25-day holding period, or about 18% annualized. Alternatively, you may want to consider selling the Dec $168 covered calls, which are going for $1.55. In this case, you are assuming a year-end rally that will lift the IWR another $3.69, and then collect another $1.55 on top of it, for a total return of 3.3%, or 33% annualized.
Lawrence Meyers is the CEO of PDL Capital, a specialty lender focusing on consumer finance. As of this writing, he did not hold a position in any of the aforementioned securities. He has 20 years’ experience in the stock market, and has written more than 1,200 articles on investing. He also is the Manager of the forthcoming Liberty Portfolio. Lawrence Meyers can be reached at TheLibertyPortfolio@gmail.com.
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