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Tales of a Technician: Portfolio Structure for Covered Calls

February 27, 2018

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In last week’s message, we laid out the three primary avenues for using the financial markets to build wealth. Our discussion provided much-needed context for an intelligent conversation on portfolio structure. And by “portfolio structure” I mean how you allocate your trading account. After all, there are many strategies and systems and even more stocks available to deploy them on.

For today let’s focus on The Cash Flow Generator And Volatility Dampener. You’ll recall this method involved the following four steps:

Tales of a Technician: Portfolio Structure for Covered Calls
  1. Step One: Build a diversified portfolio of stocks or ETFs that have listed options.
  2. Step Two: Sell covered calls on a monthly basis to reduce basis, increase the probability of profit, enhance returns and dampen volatility.
  3. Step Three: Buy protective puts to limit risk.
  4. Step Four: Invest more money in said portfolio each year to accelerate growth. Each time you accumulate another 100 shares, sell one more covered call.

How you structure this type of portfolio depends in large part on how much capital you have at your disposal. Because the covered call is the most expensive options strategy, you may be unable to carry more than one or two positions in a smaller account. Let’s walk through the logic of security selection; then we’ll build a model account together.

Pick Your Poison

When it comes down to building your cash flow account, you have two choices: use stocks or ETFs. Of course, you could also use some combination. The stock picking route offers higher risk, but higher reward. Plus, you have to deal with those pesky quarterly earnings announcements injecting large price gaps into the chart. If you can stomach the higher volatility and have a knack for picking quality, long-term growth candidates (or are piggybacking off of the Tackle 25 list), then this may be your thing.

Using ETFs offers a potentially lower risk, lower reward approach. The volatility will be dampened but so too will be the potential rewards. For our purposes today, let’s assume we want to sidestep the whole stock picking quandary and focus instead on building a globally diversified ETF portfolio.

The first order of business is to identify what segments of the market you want exposure to. Then you identify the most liquid ETF that represents it. Here are a few examples:

  • U.S. large-caps: SPY
  • U.S. small-caps: IWM
  • Emerging Markets: EEM
  • Oil & Gas: XOP
  • Metals & Mining: XME

Let’s suppose these are the core areas you want exposure to and they offer adequate diversification to satisfy even the sternest risk manager. The second step is deciding what percentage of the portfolio you want to be allocated to each bucket. Covered calls present a unique challenge since you have to buy each security in 100 share increments to make it a viable position for call selling. Let’s add the cost of 100 shares to each ticker. Since you only have to put up 50% of the capital in a margin account, I’ll add the reduced cost as well.

  • U.S. large-caps: SPY @ $278. 100 shares = $27,800 or $13,900 on margin.
  • U.S. small-caps: IWM @ $155. 100 shares = $15,500 or $7,750 on margin.
  • Emerging Markets: EEM @ $50. 100 shares = $5,000 or $2,500 on margin.
  • Oil & Gas: XOP @ $35. 100 shares = $3,500 or $1,750 on margin.
  • Metals & Mining: XME @ $38. 100 shares = $3,800 or $1,900 on margin.

If your margin is left untapped, acquiring 100 shares of each would cost $55,600. The respective percentage allocation to each is as follows:

  • U.S. large-caps: SPY (50%)
  • U.S. small-caps: IWM (28%)
  • Emerging Markets: EEM (9%)
  • Oil & Gas: XOP (6%)
  • Metals & Mining: XME (7%)

The problem with allowing the cost of 100 shares to drive the allocation is the tail is wagging the dog. The way typical allocation works is the other way around. Decide first what allocation makes sense based on your desired exposure and diversification objectives, then figure out how many shares that translates into. For example, maybe you want less exposure to U.S. markets due to their lofty valuations. And, perhaps you want more to commodity-related names for more exposure to the inflation theme. I’d like to add some foreign developed markets (like Europe) into the portfolio, but liquidity and premium in the options listed for ETFs like VGK and EFA leave much to be desired.

Here’s an example of how the portfolio may be shifted to reflect your preferences:

  • U.S. large-caps: SPY (30%)
  • U.S. small-caps: IWM (20%)
  • Emerging Markets: EEM (25%)
  • Oil & Gas: XOP (15%)
  • Metals & Mining: XME (10%)

What of Protection and Cash?

If you’re looking to acquire puts to protect you obviously have to have capital available for that. Suppose using the above allocation you end up owning around 900 shares of these ETFs. Further, instead of beta weighting let’s say you buy one put on each ETF for every 100 shares you own. You’d be looking at purchasing one put on SPY, IWM, and XME. And two to three puts on EEM and XOP. All told, the cost will run upwards of $3,000. Or, if you have a $50 to $60K account, roughly 5% of the portfolio will be dedicated to insurance purchases.

The final consideration is whether you want to be fully invested or not. Having some capital allocated to cash reduces the risk in the portfolio as well as provides dry powder to buy additional shares during corrections and bear markets. How much you hold in cash might depend on your comfort level with current market prices. If you think the market is overvalued and a bear market is imminent, then you’ll want to increase your cash levels. Alternatively, if you believe the current prices of the ETFs/stocks you’re buying are a bargain, then maybe you don’t hold excess cash at all.

There are countless possible variations to today’s allocation examples. But, this should have helped identify the critical pieces of the process and help you better discover what works for you.

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2 Replies to “Tales of a Technician: Portfolio Structure for Covered Calls”

  1. ThiagoMalena says:

    Really great article.

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