Tuesday, September 29, 2009

ETFs to Profit From Options Without Buying or Selling Options

Writing options is a powerful way to improve ROIs and generate income. In particular, options writing (selling options) is very profitable as it is a well-known fact that the vast majority of options expires worthless. So whoever sells the options ends up pocketing the premium.

In general, only investors with deep pockets can sell options. In other cases, options writing is not allowed in registered retirements accounts. Therefore, the majority of small and mom & pop investors cannot take advantage of this protitable strategy .

Powershares has a couple of ETFs that are based on options writing strategy. In essence, the ETF itself bys shares and writes Call options to improve profits ("covered calls"). This is a really interesting idea. Let's see how well they perform.

PQBW: PowerShares NASDAQ-100 BuyWrite Portfolio

This ETF tracks the Nasdaq-100, whose equivalent ETF (without using options) is the QQQQ. It seeks investment results that correspond to the price and yield of the CBOE NASDAQ-100 BuyWrite Index. It measures the returns of a theoretical portfolio of NASDAQ-100 Index stocks combined with NASDAQ-100 Index call options, which are systematically written against the portfolio. The expense ratio is 0.75%.

The 3-month chart shows well how the fund works. During the last 3 months the markets have been in an upswing. Because the PQBW writes options, its shares are called away whenever a certain price (whichever strikes were sold) target is reached, thus capping its profits.

The 1-year chart shows very well what happens in opposite market conditions. When stocks decline, the PQBW performs better as selling options will reduce the cost basis, either by generating income from Call sales.

PBP: PowerShares S&P 500 BuyWrite Portfolio

This ETF tracks the SPX (S&P500). Its equivalent is SPY. It seeks investment results that correspond to the CBOE S&P 500 BuyWrite Index (BXM). The Index is calculated by the CBOE and measures total returns of a theoretical portfolio, including the S&P 500 Index stocks, on which S&P 500 Index call options are systematically written. Its expense ratio is also 0.75%. This strategy consists of holding a portfolio indexed to the S&P 500 and selling a succession of written options, each with an exercise price at or above the prevailing price level of the S&P 500. CBOE index site.

From the CBOE site we see that the BXM Index was developed by the CBOE in cooperation with Standard & Poor's. The CBOE commissioned Professor Robert Whaley to compile and analyze relevant data from the time period from June 1988 through December 2001. The BXM is a passive total return index based on "(1) buying an S&P 500 stock index portfolio, and (2) "writing" (or selling) the near-term S&P 500 Index covered call option, generally on the third Friday of each month". The SPX call written will have about one month remaining to expiration, with an exercise price just above the prevailing index level (i.e., slightly out of the money). The SPX call is held until expiration and cash settled, at which time a new one-month, near-the-money call is written."

The 3-month chart shows the same behavior as PQBW-QQQQ. We drew circles around periods in which the market was declining and when it was rising:

Again, the ETF outperforms SPY when the markets goes down, and underperforms when it goes up.


Overall the performance is dissapointing in that it should be able to generate bigger profits by selling options. As it is, these ETFs still go down when the market goes down, and they profit less when the market goes up. This is not that atttractive. Perhaps it is the particular strike prices that are being sold that are not optimal. Perhaps it is the way this market has been working itself is not allowing the strategy to perform better.

There are clearly many alternatives to the approach they are taking with selling options at strikes at 1-month at or slightly above the current stock price. It is possible for such an strategy to ourperform in both cases when the market goes up and down. Here is an opportunity waiting for a financial institution to offer a better alternative if they really wanted to offer the benefit of options writing in a ETF product.

To receive technical analysis and alerts of these ETFs, sent automatically to you by entering the symbols in the Technical Trend Analysis Tool, (powered by INO).

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