Using ETFs For Covered Call Writing On Emerging Markets And Gold

Single stocks have a drawback in that they can be quite volatile. That's why people created mutual funds, indexes, and exchange traded funds (ETFs) -- to help smooth out the single stock volatility. ETFs are collections of securities that trade like a single stock. Because they have options available it is possible to use them for covered calls. The built in diversification they provide usually makes them a less volatile security than individual stocks. If one of the stocks that is part of an ETF drops suddenly then the effect will be felt less by the ETF that contains that stock than by the stock itself.

ETFs that track specific indexes allow you an easy way to trade the index. For example, the Russell 2000 index can be traded through the ETF with symbol IWM. There are 2000 stocks in IWM so by definition it has no single-stock risk. Other popular ETFs with many constituent components include SPY (S&P 500) and QQQQ (NASDAQ 100). Or, if you want something that follows specific sectors, countries, or commodities, you can do that with ETFs, too. For example, XLF tracks financial stocks, EWZ tracks Brazil, EWJ tracks Japan, and GLD tracks gold.

GLD is an interesting one given investor interest in owning gold. But one drawback is that GLD doesn't pay cash dividends. However, by using covered calls you can generate monthly income from gold, too. Buy a gold ETF and write covered calls (at-the-money if you're neutral on gold, or out-of-the-money if you're bullish on gold). GLD is the most highly traded gold ETF and definitely the best bet for covered call trading. UGL is 2x leveraged and therefore quite volatile, and DGL has very small open interest.

Everyone needs some exposure to emerging markets for proper diversification. But emerging markets information is hard to come by, inconsistent, and usually in a format that is difficult to digest. So it's another good example for ETFs. The most popular emerging market ETF is EEM (iShares MSCI Emerging Markets Index Fund), which has nearly $41 billion in assets and is highly liquid. Another choice, if you want to limit your exposure to just China, for example, would be to use iShares FTSE/Xinhua China 25 (FXI).

There is one kind of ETF that you should absolutely not get involved with for covered calls, and those are the leveraged ETFs. Leveraged ETFs are designed to be much more volatile than an unleveraged ETF. You can usually identify leveraged ETFs because they have words in their name like "double", "ultra", "triple", "2x", "3x", or "leveraged". Leveraged ETFs are mostly used by day traders and are not appropriate for conservative income-oriented covered call investors. It can be tempting because the premiums are usually pretty high. But there's a reason for those fat premiums, so beware! Leveraged ETFs are, by design, two or three times more volatile than their unleveraged counterpart.

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