By now, most investors are feeling pretty good. The market has been on a tear. There’s no telling when it might correct or crash. So one of the questions I get a lot in the mailbag at my stock advisory newsletter, The Liberty Portfolio, is how to make additional monthly income on top of the returns that index ETFs provide.
Great question! Index ETFs have been roaring, but they don’t really throw off a lot of income. So if you hold them, here’s how to generate income without necessarily losing your long position.
With covered calls, you are selling the right for someone else to buy a security from you at a given price on or before a certain date. If you sell covered calls on a stock and that contract gets triggered because the price has gone above that contract’s strike price, you will be forced to sell the stock.
But nothing prevents you from buying it back on the open market.
ETF Covered Calls: SPDR S&P 500 ETF (SPY)
Expense Ratio: 0.09%
The SPDR S&P 500 ETF (NYSEARCA:SPY) is that core ETF that many people own, one which holds all the stocks in the S&P 500. Here it is at $280 per share, at its all-time high. Yet it only yields 1.8% over the course of an entire year.
I see two ways you can generate income by selling covered calls on the SPY. First, you can sell covered calls that are just a single month in the future. The 23 Feb $280 covered calls are selling for $3.20. So you’ll earn $320 per contract, which is 1.15% return for just a one-month holding period.
If you want to go much further out, why not try selling the 20 Apr $280 covered calls for $5.80 per contract. That gets you $580, or a return of 2.1%.
In either case, if the SPY rises above those strike prices, and you think the SPY will get called away, just repurchase the ETF.
ETF Covered Calls: SPDR S&P MidCap 400 ETF (MDY)
Expense Ratio: 0.25%
Another terrific ETF that many investors may already own is the SPDR S&P MidCap 400 ETF (NYSEARCA:MDY). Mid-cap stocks generally perform even better than the large cap stock market over time. That’s because they have more time and market cap space to grow, since they haven’t become the big boys of the schoolyard yet.
The MDY closed at $357.12 on Wednesday. With the 23 Feb $357.50 covered calls selling for $5.35, you enjoy a 1.45% return for six weeks of holding the contract open, or 14% annualized.
If you prefer, you can look further out on these as well. The 15 Jun $360 covered calls can be sold for $7.40 each. That alone is a 2.1% return, but you add $2.88 in capital gains if it gets called away, for a total return of 2.9%.
ETF Covered Calls: iShares Russell 2000 Index (ETF) (IWM)
If you want to go after an even larger section of the market, consider the iShares Russell 2000 Index (ETF) (NYSEARCA:IWM), which owns the 2,000 smallest stocks in the Russell 3000 index. This is the index benchmark for small-cap stocks. Small caps have more volatility than their counterparts and consequently, that leads to jacked-up premiums for covered calls.
The 20 Apr $158 covered calls are selling for $4.32, earning you $432 for selling the contract. Since IWM closed at $157.64 on Wednesday, the covered calls earn you a return of 2.7%, with an additional 0.2% if called away.
If you prefer, you may want to think about checking into June’s contracts . The 29 Jun $158 sell for $6.43. That leads to a very generous return of 4%.
Lawrence Meyers is the CEO of PDL Capital, a specialty lender focusing on consumer finance and is the Manager of The Liberty Portfolio at www.thelibertyportfolio.com. He does not own any stock mentioned. He has 23 years’ experience in the stock market, and has written more than 1,800 articles on investing. Lawrence Meyers can be reached at TheLibertyPortfolio@gmail.com.