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Building a Covered-Call Portfolio


A quick guide to all your options.


Dear Professor Smith,

With option premiums still pretty high, this seems like a good time to write covered calls. But rather than pick stocks, is there currently any index or ETF where one could buy or sell calls and puts on the index itself - such as with the SPY or DIA?


S. Frankel

Dear S. Frankel,

Actually, there are a plethora of ways to create a market-based covered position. Not only does nearly every index and exchange-traded fund have related exchange-traded options, but there are also a host of funds and other products that are structured as buy-writes that offer single-stop shopping.

But before delving into specifics, there are a couple of things to be aware of. The first issue is that while the major indices have options tied to the underlying index, one cannot trade the underlying cash index. For example, the SPX and OEX options traded on the Chicago Board of Options Exchange are based on the underlying S&P 500 Index, which isn't actually traded.

Index or ETF

But to create a covered position, one would need to trade the futures on the Chicago Mercantile Exchange (CME). This distinction between the cash index and futures and options on futures holds for the NASDAQ 100, or NDX, and CBOE Dow Jones Index, or DJX.

The distinction between the cash index, its options, and the futures, does present minor obstacles in the form of slightly different contract specifications, and requires a commodity account to trade the futures. While some brokers might offer portfolio margining, others might not be considered a covered position, and therefore may have a higher capital requirement (which greatly reduces your return on investment).

One thing you don't have to worry about is divergence in performance. Because index options are cash-settled and the futures must converge with the cash price at expiration, there's no danger of misalignment of prices. Still, this isn't as clean as trading options that are fungible to an actively traded underlying security. There can be periods where the futures trade at a large premium or discount to the cash market, causing a temporary mismatch in pricing. Note: There also are options on futures contracts, which can make for a more seamless trade because they truly are covered positions.

A much simpler solution would be to use the popular exchange-traded funds, such as the Spyder Trust. Almost all ETFs have options based on the underlying security, and are settled with a delivery of the shares. This means a straightforward covered call (go long 100 shares and sell 1 call contract) can be established in broad market ETFs - such as the NASDAQ 100 Trust (QQQQ) and the Dow Diamonds Trust (DIA) as well as in sector-specific issues, such as Semiconductor HOLDRs (SMH).

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No positions in stocks mentioned.

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