traded U.S. real estate investment trusts, as repre-sented by the Cohen & Steers Realty Majors index.
Adding real estate investments helps diversify your portfolio. If you be-lieve that one or two specific sectors of the market (e.g., biotechnology)represent the wave of the future and will outperform other types of invest-ments, you may decide to allocate some of your investment capital to thoseindustries. A sample portfolio might contain:
Buy 100 BBH (Biotech HOLDRs) at $140, investing $14,000.
Buy 300 XLF (Financial Sector SPDR) at $29, investing $8,700.
Buy 100 ICF (Cohen & Steers REITs) at $106, investing $10,600.
Buy 100 MDY (MidCap 400 SPDR) at $109, investing $10,900.
Buy  500  VTI  (Vanguard  Total  Market  VIPERs)  at  $109,  investing$54,500.
SUMMARY
Although most ETFs do not have listed stock options, the variety of ETFsthat are optionable is sufficiently diverse to allow you to build a portfoliothat meets almost everyone’s needs. Table 13.1 contains the current list ofoptionable ETFs. Table 13.2 lists the optionable HOLDRs and sector SPDRs.Now that you know how to build a portfolio that meets your require-ments, it’s time to think about the type of option strategy to adopt whenmanaging your portfolio.
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TABLE 13.1 Optionable ETFs
Underlying Exchange Traded Fund
Symbol
DIAMONDs (DJIA)Nasdaq 100 Index Tracking StockFORTUNE 500 Index Tracking StockiShares Cohen & Steers Realty MajoriShares Dow Jones US Utilities SectoriShares Dow Jones US Energy SectoriShares Dow Jones US Financial SectoriShares Dow Jones US Healthcare SectoriShares Dow Jones US Technology SectoriShares Dow Jones US Telecommunications SectoriShares Russell 1000iShares Russell 1000 GrowthiShares Russell 1000 ValueiShares Russell 2000iShares Russell 2000 GrowthiShares Russell 2000 ValueiShares Russell 3000iShares Russell 3000 GrowthiShares Russell 3000 ValueiShares Russell MidCapiShares Russell MidCap GrowthiShares Russell MidCap ValueiShares S&P 100 Index FundiShares MidCap 400 IndexiShares MidCap 400 BARRA Growth IndexiShares MidCap 400 BARRA Value IndexiShares SmallCap 600 IndexiShares SmallCap 600 BARRA Growth IndexiShares SmallCap 600 BARRA Value IndexMidCap SPDRsPowerShares Dynamic Market PortfolioPowerShares Dynamic OTC PortfolioVanguard Total Market VIPERsiShares Goldman Sachs Networking IndexiShares Goldman Sachs Semiconductor IndexiShares Goldman Sachs Software IndexiShares Goldman Sachs Technology IndexiShares MSCI EAFE IndexStreetTRACKS Dow Jones Global Titans IndexFidelity NASDAQ Composite Index
Source: American Stock Exchange
DIAQQQFFFICFIDUIYEIYFIYHIYWIYZIWBIWFIWDIWMIWOIWNIWVIWZIWWIWRIWPIWSOEFIJHIJKIJJIJRIJTIJSMDYPWCPWOVTIIGNIGWIGVIGMEFADGTONQ
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TABLE 13.2 Optionable HOLDRs and Sector SPDRs
Underlying Exchange Traded Fund
Symbol
Biotech HOLDRsBroadband HOLDRsEurope 2001 HOLDRsInternet Architecture HOLDRsInternet HOLDRsMarket 2000+ HOLDRsOil Service HOLDRsPharmaceutical HOLDRsRegional Bank HOLDRsRetail HOLDRsSemiconductor HOLDRsSoftware HOLDRsTelecom HOLDRsUtilities HOLDRsWireless HOLDRsiShares NASDAQ Biotechnology SectorSelect SPDR—Health CareSelect SPDR—MaterialsSelect SPDR—Consumer StaplesSelect SPDR—EnergySelect SPDR—FinancialSelect SPDR—IndustrialSelect SPDR—TechnologySelect SPDR—UtilitiesSelect SPDR—Consumer Discretionary
Source: American Stock Exchange
BBHBDHEKHIAHHHHMKHOIHPPHRKHRTHSMHSWHTTHUTHWMHIBBXLVXLBXLPXLEXLFXLIXLKXLUXLY
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C H A P T E R   1 4
Finding Your Style
Choosing an Option to Write
You  now  own  a  diversified  portfolio  consisting  of  exchange  traded
funds  (ETFs),  or  are  ready  to  purchase  such  a  portfolio.  For  thosereaders who do not yet have enough in savings to justify the brokeragecommissions  involved  in  beginning  this  process,  you  can  begin  a  savingsprogram by paying yourself first. This means investing some money fromevery paycheck before you tackle any of your other bills. Go for passive in-vesting and choose an index fund that charges very low fees. Periodically, asyou amass sufficient funds to benefit from the recommended program, youcan cash in your index funds to purchase ETFs and begin writing coveredcalls against them. Depending on the ETFs you want to own, $10,000 may beenough to get started. Thus, even if you are not yet ready to begin this pro-gram, by mastering the investment methods described here, you will be pre-pared to do so when your financial situation allows.
Once you own your ETF portfolio, the next step is selecting which calloption to write against each of your holdings. Sometimes you have a myr-iad  of  choices;  other  times  there  may  be  just  two  or  three  options  fromwhich to choose. It’s important to understand how to think about making afinal decision. There are no wrong decisions, but you have much to gain bymaking the choice that provides the best fit for your investing style. In thischapter  we’ll  go  through  an  example,  in  detail,  showing  the  thoughtprocesses involved in considering each of the choices. That puts you in po-sition to make an intelligent decision when selecting the option to write. Inthe next chapter we’ll take an even closer look at the covered call writingstrategy as we follow a hypothetical portfolio for an entire year.
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To some readers, this attention to detail may seem tedious, but if youtake the time to study the material carefully, you will be better placed tomake decisions appropriate for both your pocketbook and your psyche.
It’s important to have confidence in your investing methods and to owna portfolio that makes you feel comfortable—from the expectation of beingable to meet both your investment objectives and your psychological needs.The following discussion includes an example of how psychology fits intothis picture.
As you proceed with the process of selecting specific options to sell,you develop a certain style. That is, you may choose to adopt a very con-servative style that focuses primarily on portfolio protection and less ongenerating profits. You may choose to be very aggressive, seeking to earnthe majority of your income by picking winning stocks. (Remember, mod-ern portfolio theory [MPT] tells you how difficult that is to accomplish.) Ibelieve that a compromise strategy seeking some portfolio protection cou-pled  with  a  good  profit  potential  is  a  winning  style.  Regardless  of  yourchoice, once you select a specific style, you don’t have to remain married toit. You can modify your investing strategy every time an expiration day ar-rives, seeking a system for writing covered call options that gives you themost satisfaction. Some investors prefer to choose one style and remainwith it for consistency; others frequently make subtle changes. The moreyou accept the premise that’s it’s unlikely that you can profitably predictthe timing and direction of stock market moves, the more likely you are toremain consistent in your style—after you discover what it is.
DETERMINE YOUR INVESTMENT OBJECTIVE
If you invest without writing any covered call options, your potential gainsare unlimited and you own your investments unhedged. If, instead, you de-cide to limit your potential profits by adopting a covered call writing strat-egy,  you  are  compensated  for  accepting  those  limited  profits  by  gainingsome portfolio protection and an increased probability of earning a profit.The  track  record  of  the  BuyWrite  index  (BXM)  discussed  in  Chapter  12shows that adopting this investment strategy under a variety of market con-ditions is expected to provide enhanced earnings.
Many investors believe they have the ability to successfully time themarket. But we have already discussed one of the conclusions of MPT: thatattempting to do so is a poor method of investing over the long term. Be-cause the methods illustrated here are based on the findings of MPT, let’s
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assume you want the portion of your assets allocated to investing in equi-ties to remain fully invested at all times. To remain fully invested, write newoptions  immediately  after  expiration  when  you  sell  options  that  expireworthless.  If  you  are  assigned  an  exercise  notice  and  sell  some  of  yourholdings, reinvest the proceeds by buying more ETFs (the same or differentones) as soon as possible. “As soon as possible” means the morning of thefirst business day after expiration.
FIRST DECISIONS
Before implementing a covered call writing campaign, two decisions mustbe made.
1. What portion of your portfolio do you want to dedicate to this strategy?The recommendation here is to write covered call options on your en-tire  portfolio  of  ETFs.  (If  you  choose  to  own  shares  of  individualstocks, you also can write covered call options against them.)
2. How do you expect to make the bulk of your profits?
a. Is your primary objective to make as much money as possible froma  rising  stock  market?  Then  you  want  to  be  writing  out-of-the-money (OTM) call options. You collect some premium from the op-tions, but your primary source of income depends on your ability toselect stocks that increase in value. This style provides very littleportfolio protection and is most successful in strongly rising mar-kets. This is not the ideal scenario for covered call writing and goesagainst the precepts of MPT, but it does allow you to aim for addi-tional profits.
b. Are your primary objectives to earn significant profits from writingoptions and to gain some insurance against loss? Then you want towrite  at-the-money  (ATM)  and/or  in-the-money  (ITM)  options  andoccasionally options that are slightly out of the money. The greatestadvantage  of  adopting  this  style  is  that  it  leads  to  earning  profitsfrom a much greater percentage of your positions. This is the rec-ommended investment style for covered call writers, and it does notleave you depending on a bull market to make money from your eq-uity investments. Writing ATM or ITM options provides greater (butlimited) protection against a market decline and works well in eitherneutral or rising markets. It also helps to reduce, or eliminate, lossesin markets that undergo small declines.
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Choosing the Call Option to Write
To get a clearer understanding of how important your investment objec-tives are in choosing which call to write, let’s consider an example. Assumeyou purchase shares of a generic ETF (whose symbol is ETFQ) at $40. Let’sfurther assume when writing a covered call option, you have the choice ofselling a call option with strike prices ranging from 36 to 44, in 1-point in-crements. How do you determine which to sell?
Options  are  always  available  with  at  least  four  different  expirationmonths. For this discussion, let’s assume you always write the option thatexpires in the front month—which means the month with the nearest ex-piration date. We’ll consider selling each of the options in turn, indicatingthe advantages or disadvantages of each. By seeing why writing each callis appropriate for some investors under some circumstances, you will gainsome insight on which option you would choose to sell under similar cir-cumstances.
Table 14.1 lists the strike price of each option, the premium (price ofthe option) you collect when selling, the amount of protection against lossit provides, and your maximum potential profit. That profit potential is di-vided into two parts. The time premium in the option is the maximum profityou can earn as a result of writing the call. The second part of the potentialprofit represents the maximum capital gain you can earn, if the stock in-creases in value and you are assigned an exercise notice at expiration.
TABLE 14.1 Option Premium for Hypothetical ETFQ Options
Price = 40; Time to Expiration = 4 Weeks
StrikePrice
OptionPremium
DownsideProtectiona
Option Time Premium
ETFQ above Strike Price
Profit Potential
363738394041424344
$4.00$3.20$2.35$1.65$1.10$0.65$0.35$0.20$0.10
10.00%8.00%5.88%4.13%2.75%1.63%0.85%0.50%0.25%
$ 0$ 20$ 35$ 65$110$ 65$ 35$ 20$ 10
aAmount stock can decline before break-even point is reached.
$ 0$ 0$ 0$ 0$ 0$100$200$300$400
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If you insist (contrary to MPT) that you have a good feel for the direc-
tion the market is going to move next, then:
• If you have a bullish outlook, write OTM calls, giving yourself the op-portunity to earn a profit if the ETF price increases. Be careful not tochoose  an  option  that  is  too  far  out  of  the  money,  because  the  pre-mium you receive is too small and it’s not worth the effort
• If you have a neutral market outlook (per MPT), write an option that isclose  to  the  money,  allowing  yourself  to  collect  the  maximum  timevalue.
• If your outlook is mildly bearish, you can gain extra protection against
a market decline by writing ITM options.
• If you are very bearish, don’t adopt a bullish strategy (such as covered
call writing).
The following represents some of the thoughts you may have when de-ciding which option to write. The discussion is in the first person and mayseem repetitive, but once you go through the process once or twice, youwill find it much easier to make the necessary decisions each time. By tak-ing the time to understand the process now, decision making becomes amuch simpler process.
Thought Process Involved in Considering Each Option as a Sale Candidate
Let’s consider writing each option in turn and consider the arguments forand  against  choosing  each  specific  option.  Investors  following  differentagendas can make a good case for choosing any of several of the optionslisted. Consider the reasons stated for selecting each option. The argumentthat makes the most sense to you provides a good hint as to how you shouldbegin when you get started with this investment method.
Writing the 44 Call The $10 I can earn is a tiny potential return. WhenI deduct the cost of making the trade, there’s not much left for me and lit-tle to recommend this action. I don’t want to write calls for such a smallpremium. It’s extremely likely that this option is going to expire worthlessbecause it’s so far out of the money, but the reward for selling it is simplytoo small to consider.
Writing the 43 Call This choice is a bit better. Making $20 (before com-missions) on an investment of $4,000 represents a return of only 0.5 percent.Although nothing to get excited about, if I earn an equivalent return monthafter month, my annual return is boosted by about 6 percent. That’s the equiv-
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alent of collecting a healthy dividend. In addition to earning this $20, I havethe opportunity to gain another $300 if the underlying ETF increases in valueby at least three points before expiration. That’s a rise of 7.5 percent and nota likely occurrence. If I write the 43 call, I must give up the opportunity toearn even more than $300, but I’m willing to do that because it is so unlikely.I’m willing to accept the $20 as payment for giving up that opportunity.
Conclusion:  This  is  a  reasonable  option  to  write,  but  only  when  I’mstrongly bullish. It’s not a good choice when I have no opinion on market di-rection because the premium is pretty small. I doubt I’ll ever want to writean option to earn a smaller return than this.
Writing the 42 Call This choice is pretty similar to writing the 43 call. Icollect a slightly higher option premium and sacrifice the chance of makingan extra $100 in the event of a big rally. In this case, the potential profit of $35from the option sale represents a return of almost 1 percent. Again, that’s notenough to get me excited about the prospect of writing covered calls, but itdoes allow me to maintain a bullish posture and collect a nice extra premiumthis month. I think it’s a good trade-off to take the extra $15 up front and giveup on the chance of making an extra $100 if there is a big rally. After all, ifETFQ rises to 42, that’s a 5 percent increase for the month and a pretty sig-nificant move. I’ll be quite pleased with my profits if that happens, and it’s notnecessary to hope ETFQ moves all the way to 43. This is a long-term invest-ment strategy, and I don’t have to make the maximum possible profit everymonth. My goal is to accumulate steady profits over the long term.
Writing the 41 Call The strategy followed by the BXM calls for writinga call option with the first OTM strike price. For ETFQ this month, that’sthe  41  call.  If  it’s  good  enough  for  the  Chicago  Board  Options  Exchange(CBOE) to use as their model, perhaps it should be good enough for me.The potential profit of $65 per option represents a return of 1.65 percent fora one-month holding period, or 19.6 percent annualized (without consider-ing the benefits of compounding). There’s even the possibility of earning anadditional $100, if ETFQ closes above the strike price of 41 on expirationFriday. Writing this call option is an excellent choice for me as it allows meto collect a decent option premium and still participate in a market rally.My downside protection is reasonable (0.65 per share, or 1.65 percent).
Writing the 40 Call Writing an ATM option has three things to recom-mend it.
1. This call option has more time premium than any of the other options.(Reminder: total option price equals time premium plus intrinsic value,if any). And it’s the time premium in an option that represents my po-tential profit when I sell it.
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2. It  provides  a  decent  amount  of  protection  in  case  the  market  drifts
lower (2.75 percent).
3. It provides a nice profit when the market moves sideways for a periodof time. If ETFQ is unchanged on expiration day, I’ll earn 2.75 percent,and that’s a great return when my money is invested in a position thatgoes nowhere. Of course, that 2.75 percent also represents my maxi-mum potential profit for the next month, but I’m willing to accept thatin exchange for gaining some downside insurance and the chance toprofit if my holdings are flat for the month.
Selling this option is a good compromise strategy and I find it quite at-tractive. In fact, I may choose to alternate between selling the call that isjust out of the money in some months and the ATM call in other months.
Writing the 39 CallI notice the 39 call has the same time premium asthe 41 call. This is not always going to be the case, but it does happen. Ifearning a profit of $65 on an investment of $3,835 appeals to me, then I havetwo choices. When I write the ITM call, I cannot earn any additional profitif the market goes higher. But, in return, I get 1.65 points of downside pro-tection. Writing the 41 call gives me the opportunity to earn the same timepremium from the option, plus an extra $100 if ETFQ increases in value, butprovides  insurance  of  only  $65.  My  choice  is  between  having  an  extra  1point of downside protection or the possibility of earning an extra 1 pointof possible profit. I’ll choose the 39 call if I am an investor who prefers extrasafety.
Writing the 38 Call This is a pretty conservative play. If I sell the 38call for $235, I’m protected all the way down to 47.65, a drop of 5.88 per-cent. Of course, in return for this “free” insurance, my profit potential isonly $35 per contract, or 0.88 percent, and that’s before commissions. Thisis not the type of call I want to sell on a regular basis, yet for those timeswhen I am deeply concerned about the direction of the stock market, it pre-sents me with an opportunity to remain fully invested (something I decidedI want to do, as trying to time the market is not a winning strategy) and earnsome income for the coming month. I’ll usually want to write options witha greater profit potential, but writing the 38 call allows me to sleep at nightduring my current uncertainty about the stock market.
Writing the 37 Call The potential return is a pretty dismal $20 per con-tract, and that’s only 0.5 percent. I’d have to be very worried about the mar-ket to accept such a small return. It’s true that I would be protected againstloss if ETFQ drops 8 percent, but I won’t usually require that much protec-tion for only one month. Conclusion: This is not a good choice for me.
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Writing the 36 Call This option trades at parity. That means the totaloption premium is equal to the option’s intrinsic value, and there is zerotime value. Because my potential profit is the time value, writing this optionis  not  a  possibility  because  there  is  no  potential  profit.  As  options  getdeeper and deeper in the money (i.e., as the strike price decreases for calloptions), time value decreases. If the option is deep enough in the money,time premium approaches zero and there is no reason to write such an op-tion in a covered call writing portfolio.
Summary: Which Call to Write?
When you begin writing covered calls, the way you feel about your posi-tions  gives  you  a  great  deal  of  insight.  If  you  are  comfortable  with  yourpositions, then your choice of which call option to write is probably appro-priate for you. If you are nervous and literally lose sleep worrying aboutyour  investments,  then  your  choice  is  not  appropriate.  It’s  impossible  tomeasure the psychological importance of being confident with your invest-ment choices, as constant worry is not good for you. The good news is thatcovered  call  writing  provides  a  reduction  in  the  overall  risk  of  being  in-vested  in  the  stock  market  and,  thus,  should  help  reduce  anxiety.  Thatalone provides sufficient reason for many investors to find a place in theirportfolios for writing covered calls on ETFs.
When expiration arrives, there are only two possible outcomes for each
of your ETF positions.
1. The options expire worthless.
a. Next  Monday,  in  order  to  remain  fully  hedged,  write  new  optionsagainst your holdings. Expiration weekend is a good time to studythe  various  choices  available.  That  minimizes  the  time  you  mustspend making the final decision on Monday.
b. You probably will maintain ownership of ETFs you currently own,but if you prefer to own different ETFs, immediately after expirationis a convenient time to sell some of your holdings and switch intodifferent ETFs.
2. The options expire in the money. You are going to be assigned an ex-
ercise notice. You will be forced to sell your ETFs.
a. Next  Monday  reinvest  the  proceeds  of  the  sale  and  write  call  op-tions. You can reinvest in the same ETFs or buy new ones. You planto remain fully invested at all times. The weekend is a good time todecide which ETFs you want to own.
There is no better time than the next trading day—generally the Mon-day morning after expiration—to write new calls on your existing positions
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or to reinvest cash in a new covered call position.1 We’ll talk more aboutthis process later, including how you can avoid being assigned an exercisenotice by taking action prior to expiration.
CONSISTENCY OR FLEXIBILITY?
After you find the general style that fits both your investment objectivesand your comfort level, there is a decision to be made. You can choose tofollow the same strategy every month, unless there is a compelling reasonto make a change. Alternatively, you can decide at the last minute which op-tion  writing  style  to  follow:  from  the  most  aggressive  (writing  OTM  op-tions) to the most conservative (writing ITM options). Being consistent issuggested by the teachings of MPT, which tells you that guessing market di-rection or trying to time the market is inefficient. However, human natureis not always easy to ignore, and you may find yourself being overly bullish(write OTM calls) or bearish (write ITM calls). It’s your money, and youmake these decisions. There is no right or wrong way to make covered callwriting work for you. Satisfying your psychological self is an important as-pect of investing. You do not want to be second-guessing your decisions, soit’s important to be able to accept those decisions, once you make them.One of the objectives in adopting this strategy is to feel good about yourportfolio and the potential profits.
HISTORICAL RESULTS
Because the BXM adopts the strategy of always writing an option with astrike price that is just out of the money, you may feel comfortable adopt-ing that strategy as well. It’s only slightly bullish and allows you to partici-pate in market rallies. Because the general trend of the stock market hasbeen higher over any extended period of time, it’s reasonable to adopt astance that makes good money in rising markets.
Of course, there are many alternatives. For example, you may want tobe more bullish on specific ETFs and more conservative on others. Or youmay want to change your strategy after each expiration date to suit yourcurrent market outlook. There is no single correct way to use covered callwriting. With my personal investing, I remain consistent and almost alwayschoose  a  conservative  approach,  writing  options  that  are  slightly  in  themoney. But that might not be suitable for you.
Thus, you must decide whether to accept a consistent strategy everymonth or to vary your technique. There’s no hurry in making this decision.
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You’ll get to know more about covered call writing and how well it suits youwith each passing expiration period.
If you do your homework over expiration weekends, this investmentmethod  doesn’t  take  much  of  your  Monday  morning.  You  may  prefer  toallow someone else to enter your trades for you. One important point mustbe made. If you appoint someone else (broker or financial planner perhaps)to  enter  your  trades,  it’s  best  to  determine,  in  advance,  which  style  youwant to use. I strongly suggest you allow that advisor almost no discretionwhen  entering  orders  and  do  not  allow  your  agent  to  determine  overallstrategy or to time investments. This prevents misunderstandings and badfeelings, and allows you to invest as you see fit.
GETTING STARTED
If these ideas appeal to you, you may be eager to begin. But please read thenext two chapters carefully before taking the plunge. This advice is espe-cially important if you are new to options trading. It takes you through theprocess by building a fictional portfolio and managing it through an entireyear of trading. There are some winning months as well as some losers. Youlearn the types of trades you can make before expiration to avoid sellingyour underlying ETFs and how to adjust a position to reduce risk. Whenadopting this strategy, your results are going to depend on the performanceof the overall market, but this method increases your chances of beatingthe  market  when  compared  with  picking  stocks  or  mutual  funds  onyour own.
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C H A P T E R   1 5
Covered CallWriting in Action
A Year of Trading
Theory’s great, but how does all this work in the real world? What kind ofresults can you expect? How do you handle the month-to-month decisions?Are  there  going  to  be  special  situations