In this strategy we are going to review is the concept of writing covered calls to generate income.
Covered call writing consists of selling call options against your existing stocks. To implement the strategy, you first must own the shares of the ETF and then sell 1 call for every 100 shares you own. In taking that action, you get paid cash upfront for giving someone else the right to buy your ETF at a specific price over a specific time.
When you combine this strategy of Covered Call writing with ETFs, you create an effective way to generate consistent cash flow from the stocks you own, a way to reduce your cost base of your investments and way to ensure your money is always working for you.
Lets apply this strategy to the iShares CDN Large Cap 60 index Fund (XIU)
In this example, the XIU is trading at $12.50 a share. Through your analysis, you are anticipating the market to be range bound for the next 4 months. With an upside range of $13.50, our objective is to generate some income while we wait for the markets to turn around.
When we look at the 4 month $13.50 covered call, it is bidding $0.55 cents per share. If we purchased 1000 shares of the XIU at $12.50 dollars it would cost us $12,500.00. We then sell 10 calls against the XIU shares and generate $550.00 cash flow income.
That $550.00 represents an up front 4.40{bcb10712eadb32c7e50a15bcbfb14ed4d7108a9fa2a5dcafffbff4bd1d9a4f28} guaranteed cash flow. Real money that you made today!
We got paid that cash, because we are giving someone the right to buy our XIU shares at $13.50 over the next 4 months.
Let’s look at the different outcomes – We originally purchased 1000 shares at $12.50 for a total of $12500. We then sold the 10 calls and generated $0.55 cents a share or a $550.00 cash flow creating a new reduced average cost of $11.95 or for a $11,950 net debit.
If the XIU was to have rallied above the $13.50 level by the end of the 4 months, then your shares will be assigned and you will sell your shares at that $13.50 strike price or $13,500
That represents a $1550 profit over your adjusted cost base, representing close to a 13{bcb10712eadb32c7e50a15bcbfb14ed4d7108a9fa2a5dcafffbff4bd1d9a4f28} return in just 4 months!
Alternatively if the XIU is anywhere below the $13.50 price at the end of the 4 months, you will continue to own the XIU shares while getting to keep the 4.40{bcb10712eadb32c7e50a15bcbfb14ed4d7108a9fa2a5dcafffbff4bd1d9a4f28} cash flow. While creating a new adjusted cost base an you are now free to write new covered calls.
The second strategy we are going to review is the principle of selling puts to generate income on ETFs.
Selling puts is an excellent way to generate cash flow in your portfolio and a solid way to average down your cost on existing ETF positions. Also, this is an excellent, alternative way to buy into a market.
What does it mean to sell a put?
When you sell a put, you get paid cash upfront for giving someone else the right to sell the shares to you at a specific price over a specific period of time. You would sell 1 put for every 100 shares you are willing to own.
Lets apply this strategy again to the iShares CDN Large Cap 60 index Fund (XIU) Again, in this example, the XIU is trading at $12.50 a share. Through your analysis, you are anticipating the Canadian market to be range bound for the next 4 months. With a downside range of $12.00 or roughly 4{bcb10712eadb32c7e50a15bcbfb14ed4d7108a9fa2a5dcafffbff4bd1d9a4f28} lower than where the market is today.
Our objective is to generate some income while we wait for the markets to turn around. When we look at the 4 month $12.00 strike put, it is bidding $0.87 per share. If we sell 10 puts, it would generate $870.00 cash flow for being obligated to buy 1000 shares at that $12.00 price.
That represents a 7.25{bcb10712eadb32c7e50a15bcbfb14ed4d7108a9fa2a5dcafffbff4bd1d9a4f28} cash flow return for being obligated to buy the XIU shares at $12.00 over the next 4 months. If you are assigned on the XIU, you will now own the 1000 shares at an average cost of $11.13 per share. That represents the $12.00 purchase price minus the $0.87 cash flow.
This is a reasonable way to average down on your existing positions or using it as an entry strategy for accumulating new ones.
Alternatively, if the XIU is trading above the $12.00 price come the expiration, the put will expire. You will get to keep the profits, and you have no further obligations.
To summarize, covered call writing and put writing are excellent and conservative strategies to generate consistent cash flow in a portfolio. Best of all covered calls are eligible in registered accounts. While put writing is limited to standard margin accounts.
