Equity ETFs: Good Market To Write Options In – Part II

Part II

I’m going to pick up from where I left off in Equity ETFs: Good Market To Write Options In – Part I.

Both of these articles, Part I and Part II, are more in an essay format to give you a real-world feel as to why I believe writing (selling) options here is a great way to augment your income, especially now with the major market averages at close to their highs.

I’ve already said that you want to be a seller (writer) of options, not a buyer since the “time premium” then works in your favor. I like to compare it to the gambler in a casino as the buyer of the option while the casino itself is the seller of the option. That is, the gambler may win every now and then, but over time, the casino is almost always the long-term winner.

Why is that? Because options have two variables that establish the price of the option based first on the current price and volatility of the underlying security and second, on how long the contract lasts for. The first is called the strike price and the second is called the expiration date.

When you write an option, a Call option for example, you need to pick the strike price of the option relative to the current price of the underlying stock or ETF.

For example, the S&P 500 (SPY) closed at $455.02 on Wednesday, Nov. 22, just about -5.5% off its all-time high set at the end of 2021 when liquidity was plentiful and the Federal Reserve hadn’t even started raising interest rates yet.

SPY is my largest position, and because of its size and popularity, there are LOTS of options available on SPY. Let’s say, however, you would be happy giving up 100 shares of your SPY into early next year at a $460 strike price, only about 17 points from an all-time high, and you are willing to have someone pay you a premium over and above that $460 for that right.

That’s what an option allows you to do. One thing to remember. 1 option contract = 100 shares of the underlying stock/ETF and if you only owned 80 shares, you would need a Level 3 options approval, since you would be slightly “naked” on the 20 shares that you were short.

I realize that 100 shares of SPY would equal $45,502 and that might be too large of a position for some of you, but there are lots of ETFs, including geared +2X and +3X ETFs, that are correlated to SPY but have much lower prices while having higher volatility. That can mean adding premium that you can sell. For this example, however, I’m going to use SPY.

So you’ve established your strike price at $460 since typically, you want to sell a Call option “out of the money” in which $456, $457, $458 and $459 or higher would all be considered “out of the money” since they are all higher than the current $455.02 price on SPY.

You could go even higher than $460 but just remember, the higher the strike price over the current market price, the less the option contract is going to be worth since the higher the strike price, the more difficult it will be for SPY to rise to by the time the contract expires.

On the other hand, a $456 strike price, which is only slightly higher than the current $455.02 price, is going to have a much higher premium price than the $460 strike price. Also remember, you are establishing the contract price of what you are willing to give up the shares for.

Next, you would need to establish your expiration date, and like the strike price, you have plenty of variables to choose from. But the expiration date is pretty straightforward compared to the strike price, where the farther out you go, the more the contract is worth.

I usually like to go out 1-3 months depending on where we are in the calendar year since seasonality does make a difference. For example, this summer during the market run-up in July, I used three-month options out to October since October is usually a down month and so the likelihood that the options would expire worthless is greater, and that’s good for you as the seller of the option and bad for the buyer of the option.

Plus, going out three months meant the option time premium was very high compared to if you only went out one month to August. The last thing to know about expiration dates is that over the years, the expirations were always on the third Friday of a given month. So, for example, if we were going to sell a SPY option here in December, it would normally expire on Friday, Dec. 15.

But because of SPY’s size and popularity, many ETFs and popular stocks now have weekly expirations and even daily expirations now, called ODTE (One Day To Expiration) options, which just goes to show you how popular options have become and how many investors are willing to gamble on the daily moves in the markets.

Note: The volume of ODTEs being traded every day is supposedly a big contributor to the market volatility and momentum, whether it be up or down.

But for most securities, you’ll find that expirations out each month are on the third Friday of the month or the last business day of the month.

So, for this example, I’m going to look to sell 1 Call contract of SPY at a $460 strike price out to Friday, Jan. 19, since market seasonality could still be positive in December and I also want to push out the expiration to next year for tax-purposes.

So a January 19th expiration gives us almost two months of time premium. And when I look at the bid/ask price for this contract, the $460 strike price closed at $6.52 bid and $6.55 ask.

What does that mean? It means that if you wanted to sell the contract right away, you could do so at $6.52. I usually like to put in at the ask price since with the volume of SPY option contracts, you will usually get executed at the ask price, though for lower volume contracts, you might want to just go with the bid price.

So we sold 1 SPY Call 460 strike out to Jan 19, 2024, at $6.55. What does that mean? Well, since each contract is worth 100 shares, you would take in $655, which will be carried as a debit in your portfolio. And because it is a debit, the smaller it gets, the more money you make. So ultimately, you want it to go to zero.

Let’s first determine what the annualized return would be if you could do this every two months. We sold 1 Call contract of SPY at a $460 strike price out to Friday, January 19th for $6.55. That’s $655 X 6 (two-month increments) = $3,930, so if you could do that every couple of months, your annualized yield on 100 shares of SPY at a total current value of $45,502 would be 8.6%.

That’s not too bad considering the $460 strike price is pretty far “out of the money” and it’s less than two months before expiration. But say you thought we were going to go nowhere in the markets over the next couple months and instead, wanted to sell 1-contract “at the money” at $455 out to Jan. 19, 2024.

Well, all of a sudden, that contract price would jump to $9.35 to sell. So annualized, that equates to a much higher $5,610 if you could do that every two months (not likely with the strike price so close to the current market price).

But if you could, now the annualized yield jumps to 12.3%. And if you went out one more month to a February 16th expiration (the third Friday in Feb), the $455 contract price would jump to $13.10 or $1,310 you would keep if SPY went nowhere over the next three months.

The point is, you can adjust how much you are willing to sell the contract for based on the strike price and the expiration date.

Why is this better than a stock or ETF or a CEF that yields the same? The biggest reason is that when a stock, ETF or CEF goes ex-dividend, it is reduced by the distribution before it starts trading that day.

So when you hear about big, fat, juicy dividends, distributions and yields, you’re probably left with the impression that this is on top of whatever the price appreciation (or depreciation) of the stock, ETF or CEF offers. This couldn’t be farther from the truth.

If the dividend or distribution was simply an amount separate from the current market price of the security, then that would be wonderful. But unfortunately, it is not and that’s why I always harp on NAV growth for CEFs as being so critical to a fund’s success. Because if a fund can’t reasonably be expected to make up its distribution, either through portfolio appreciation, interest or in many cases, option writing, then the yield, no matter how high it is, does you no good if the NAV and, by extension, market price, ultimately can’t make up the distribution or even a portion of it.

And this is why the vast majority of CEFs lose NAV over the years. Because most of them cannot cover a high NAV yield year-in and year-out, which I define as 12% or higher.

But when you write options against stocks or ETFs, surprisingly the dividend and distribution reductions that stocks and ETFs go through work in your favor if the ex-dividend date is during the time you own a written option.

Note: CEFs don’t have options. Only stocks and ETFs can have options.

For example, SPY pays a quarterly dividend and will go ex-dividend in mid-December at roughly $1.80/share. That means SPY’s market price will be reduced by $1.80 on its ex-dividend date.

Now is that priced into the option you’re selling out to January? To a degree, yes but more importantly, that ex-div reduction in market price only helps the probability that your “at the money” or “out of the money” option expires worthless.

And don’t forget, you’re still getting paid that $1.80 dividend too on the shares of SPY you own. But just like all other ETFs, stocks and CEFs, SPY would have to first make up that $1.80 before you could say it was earned.

So do you see how writing options can result in added annualized income and yield whereas in stocks, ETFs and CEFs, it would first have to make up its dividend or distribution amount and yield?

If that sounds like it’s almost too good to be true, then that’s the point I want to get across. But like everything in the markets, there’s a downside to selling options. Though in many ways, it’s more limited than say, the downside of a buyer of an option.

The downside to selling Call options, if you’re long the underlying security like SPY, is if the markets continue to go up and appreciate higher than your strike price. So using the example above, if SPY appreciated over $460 (even while making up the ex-div amount too) by January 19th of next year, then the option has moved to ‘in-the-money’ and you are subject to getting called away at the $460 strike price at expiration.

That means, you would give up your shares at $460 though you would realize the appreciation from the $455.02 current market price as well as keeping all of the $655 or $6.55 contract price you sold the option for.

Clearly, that’s not the worst thing in the world to have happened. In fact, your breakeven on selling the option would be the strike price plus what you sold the option for, or $466.55.

So if SPY went higher than $466.55 by the expiration date, then it would have been better to just have held on to SPY and not sell the call option. But anything below that $466.55 price means you would actually have made money even if you were exercised at the $460 strike price.

And by the way, $466.55 on SPY would only be about 10 points away from its all-time high, and that’s excluding all the dividends paid on SPY since December of 2021 when it made its high.

In other words, SPY has paid $11.04842 in dividends (yes, I keep very detailed records on SPY) since the December 2021 highs, so if you added that back to SPY’s current market price, or $466 say, which is right about your break-even price, that’s only 3% away from SPY’s all-time high around $480.

So there’s a lot to feel optimistic about if you sell say, a SPY Call 460 strike out to Jan 19, 2024, at $6.55. Because if SPY goes nowhere until January 19th, you keep that $655 and if SPY goes down, you still get to keep that $655 and thus, serves as an offset to the first $6.55 of downside in SPY to roughly $448.50 ($455.02 current price – $6.55).

But even if SPY keeps going up, the time premium, in this case it would be the entire $6.55 since the contract already starts “out of the money,” will still erode to zero by expiration.

For example, let’s say SPY was at $463 the week of expiration, or $3 “in the money” from the $460 strike price. But if there were only a few days left before expiration, the time premium erosion would mean that the contract would only be worth the $3.00 in-the-money plus a few days’ worth of time premium left, and let’s say that’s worth $1.05, for a total of $4.05.

That means that $2.50 of time premium ($6.55 – $4.05) would have eroded even though SPY has gone up 8 points from $455 to $463. And this is the main reason why selling options is so much more advantageous than buying options.

Because even though SPY has gone the direction the buyer of the option wants, he can still lose on this bet because he’s run out of time. On the other hand, time works in the seller’s favor since even though SPY has gone up 8 points, he/she could buy back the contract, called “buy to close,” and realize a $250 gain ($655 sold to open – $405 buy to close) on the option as well as the eight-point appreciation on SPY.

And what could you do at this point? Well, by buying back the option, this frees you up to re-sell another Call option out to say, two months to the March 15 expiration at an even higher strike price, which with the premium taken in, would be even closer to SPY’s all-time high.

Conclusion

I hope all of this has been of value to you and provides a compelling argument that writing options on ETFs is another income and yield strategy you might want to consider in addition to the income and yield opportunities that CEFs offer.

Clearly though, the outlook for both income strategies depends heavily on where the markets go from here. If over the next year, the markets are flat to up and down but no clear trend is established, then the option write strategy on ETFs should be more profitable.

But if we see a more difficult market environment going forward in 2024, then my biggest worry is that the liquidity withdrawal that the Federal Reserve is going to continue with, even if they stop raising rates, will certainly have a more detrimental effect on lower volume securities like equity CEFs. And though ETFs would probably suffer too, the option-write strategy can offset that depreciation to a degree.

On the other hand, if we see a ramp-up bull market in 2024, then equity CEFs will certainly participate while the option-write strategy will limit the upside in those ETFs.

That’s exactly what happened in July of this year when the markets rallied all through June and July and I had to close out some July written options on ETFs at a loss while letting others get called away, i.e. I lost the shares at the given strike price.

And currently, I’m down on some of my written January Call option expirations too though I also put some on back in July at near the high which I’m still up on due to the time erosion.

What you find out in the financial markets is sort of what you find out in life. It’s all about timing and thus, putting yourself in a position to take advantage of opportunities at the right time. And though options may not be quite at the same level as life, there is no question that timing options, whether you are a buyer or a seller of options, will make a big difference in whether they work out or not.

I just firmly believe that selling options yourself when the markets have run up gives you a much better opportunity to be successful due to the fact that in two out of the three market scenarios going forward, i.e. a flat market environment and a down market environment favor the option write income strategy whereas only a continued ramp-up, bull market environment does not.

And this is something that most option-write CEFs and ETFs don’t do. They don’t have the luxury of timing when their options are sold since they typically write options systematically every month, no matter where the market indexes are at the time. And as a result, most of these funds have not done very well, particularly this year.

My gut feeling is that 2024 will not be as bullish as the consensus thinks, at least not for the first half of the year, though the second half will depend on if the Federal Reserve goes ahead with its rate cuts. Thus, I’m more of the expectation of a flat, up-and-down market environment in which no clear trend is established.

My main reason for this outlook, at least for the first half of the year, is that none of the problems of higher rates has really shown up in the economy yet though I still believe they will. In fact, one could argue that the only negative impact we’ve seen so far has actually been in the financial markets in which, except for a handful of mega-cap technology stocks and the major market indexes, most everything else has struggled for the past two years.

Finally, this exercise does not even touch upon the myriad of other option strategies that are available, including straddles, collars or writing Put options, which I sometimes use as well. But my goal here was to try and introduce you to one of the more common option strategies available and how I use them to generate income.

I also wanted this to be more of a real-world step-by-step guide rather than including lots of graphs and tables. Though there may be times in which you say to yourself “why did I sell that Call option when all it does is keep going up,” I believe over time, the odds will be in your favor to make profitable write option trades when the markets have run-up like this.

Just let time work in your favor.