Covered call writing results can be enhanced through the use of leveraged ETFs and margin accounts. However, so too is the risk elevated. In this article, the pros and cons of these strategies are examined.
Definitions
Leveraged ETF: An exchange-traded fund (ETF) that uses financial derivatives and debt to magnify the returns of an underlying index.
Margin account: A brokerage account where the client has the ability to borrow money from the broker to buy securities. The loan is collateralized by the cash and securities in the account.
QQQ: This is the ticker symbol for the Nasdaq 100 Trust, an ETF that trades on the Nasdaq exchange and consists of 100 of the largest non-financial companies that trade on the Nasdaq.
TQQQ: ProShares UltraPro QQQ seeks daily investment results, before fees and expenses, that correspond to three times (3x) the daily performance of the NASDAQ-100 Index. Since goals are daily-based, longer-term results will not usually coincide with triple the returns of QQQ.
6-month comparison chart as of 6/27/2016
QQQ and TQQQ Comparison Chart
In the past 6 months, QQQ is down 2.5% while TQQQ is lower by 15%, clearly reflecting much worse than long-term triple results and highlighting the risk involved with leveraged ETFs. Of course, if QQQ had appreciated over the same time frame, TQQ would have appreciated significantly more.
Calculation results for slightly out-of-the-money strikes using the Ellman Calculator
QQQ-TQQQ Calculations
QQQ has the potential to generate a 1.6% (1.5% + 0.1%), 1-month return while TQQQ offers the possibility of a 3.4% (2.9% + 0.5%), 1-month return, highlighting the advantage of leveraged ETFs.
Margin accounts
If trading was in a margin account where 50% of the cash is borrowed to buy the leveraged ETF, the gains and losses would be magnified by approximately two-fold, accounting for the cost to borrow (interest paid to broker). We must also factor in the chance of margin call wherein if security prices fall to a certain level, investors may be required to add more cash into the account or sell certain securities perhaps at a loss. Click here for more on margin accounts.
Discussion
Utilizing leveraged ETFs and margin accounts is not appropriate for most retail investors because of the enhanced risk inherent with these strategies. However, for some sophisticated investors with a high risk-tolerance, these tools may be appropriate.
Upcoming live events
November 5, 2016
Plainview, New York
Saturday morning 3-hour workshop at the Plainview Holiday Inn. I am the only speaker and plan an information-packed presentation covering 5 actionable ways to make money or buy a stock at a discount using both call and put options. We will also evaluate the stocks you currently own for option-selling. Bring a list of stocks currently in your portfolio.
December 6, 2016
Options Industry Council Webinar Summit
Tuesday afternoon…information to follow:
Market tone
Global equities advanced slightly this week. While it is early in the third quarter earnings season, reports seem to indicate that the earnings decline of the past four quarters may be ending, with S&P 500 Index earnings expected to rise by 0.5% this quarter. Revenues are also expected to increase, by 2.5%, according to Thomson Reuters. Volatility, as measured by the Chicago Board Options Exchange Volatility Index (VIX) declined to 13.38 this week from 15.2 a week ago. US oil prices moved a bit higher, with West Texas Intermediate crude advancing to $51 from just above $50 last week. This week’s reports and international news of importance:
US Federal Reserve Vice-Chair Stanley Fischer said this week that the central bank is very close to achieving its twin goals of full employment and inflation near 2%. The comment seems to indicate a probable hike in the federal funds rate at the December meeting of the Federal Open Market Committee (FOMC
The Fed’s Beige Book, prepared in advance of the November FOMC meeting, said that economic activity increased at a modest to moderate pace in most US regions
Inflation in the United Kingdom rose 1% in September, the fastest annual rate in two years
The Chinese economy continued to grow at an annual rate of 6.7% in the third quarter, unchanged from the prior two quarters. The economy appears to have stabilized after turbulence in late 2015 and earlier this year, but economists worry that much of the growth is being driven by an unsustainable credit surge
The Kingdom of Saudi Arabia this week sold a total of $17.5 billion 5-, 10- and 30-year bonds, the largest single bond sale ever for an emerging market
Matching an 11-year low, the UK unemployment rate held steady at 4.9% in the three months ending August 31st
Labor markets have largely shrugged off Brexit concerns thus far, though the process of leaving the European Union has yet to officially begin
The European Central Bank left monetary policy unchanged at its October 20th meeting and did not extend its quantitative easing program, which is scheduled to expire in March 2017
The Bank of Canada lowered its outlook for economic growth for the balance of 2016 and for 2017, citing weak exports to the United States as a result of low US business investment and on increased global competition
There was an uptick in the Philadelphia Fed Manufacturing Index (9.7 versus 5.3 expected)
Existing home sales (3.2% versus 0.4% expected) beat expectations
However, there was a drop in Empire State Manufacturing Index (-6.8 versus 1.0 expected) and a decline in housing starts (-9%, on a decline in multifamily units
Single- family starts were solid
THE WEEK AHEAD
Flash purchasing managers’ indices are released globally on Monday, October 24th
September US durable goods orders are reported on Thursday, October 27th
Japan reports its September consumer price index on Friday, October 28th
US preliminary Q3 GDP is released on Friday, October 28th
For the week, the S&P 500 rose by 0.38% for a year-to-date return of +4.76%.
Summary
IBD: Uptrend under pressure
GMI: 1/6- Sell signal since market close of October 12, 2016
BCI: My plan for the November contracts is to continue to favor in-the-money strikes 2-to-1. I’m factoring in the upcoming election and Fed watch.
WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US
The charts point to a neutral to slightly bearish outlook. In the past six months the S&P 500 declined by 1% while the VIX rose by 5%.
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Wishing you the best in investing,
Alan (alan@thebluecollarinvestor.com)