Did our first ETF covered call: UNG

July 11th, 2009 · 12 Comments

Dipping our toes in the water a bit this week, we did our first ever covered call trade (also called a buy-write.)  Given our small GI portfolio size (only a couple thousand $ transferred and available for transactions at TradeKing), we chose to use the ETF known as UNG as the underlying, and a July $13 strike as the call (UNY GM).  You might be asking “Why?” about now.

Growing our returns

Growing our returns

To reiterate from other posts on this blog, our goal is to increase our return on assets by starting to trade options.  The thinking is that selling call options against assets we might otherwise be just buying-and-holding will help our return no matter which way the market is moving.  Just to be explicit, we’re not picking trades solely based on income from selling the calls but instead looking for opportunities where (a) we’re willing to hold the underlying for long-ish periods, and (b) there is a reasonable premium associated with selling the call.

In this week’s case, we used the weekly post over at ETF Covered Calls in order to quickly screen for ETF’s that fit a couple criteria:

  • The underlying’s price needed to be less than $20/share due to limitations on our funds available for the trade.  (Actually, the net debit on our account needed to be less than that, but the underlying’s quote is a good first order proxy.)
  • The underlying and call option needed to have “good” liquidity, where “good” to us meant over 1M shares trading in the underlying, and 1K in call options.
  • A decent premium for selling the call, certainly one that overcomes our transaction costs.  That is selling a call for a quoted $0.10 (i.e. $10 total) actually gets eaten up completely by any in- and out-direction transaction costs.

Because part of our plan is that we have to be willing to buy-and-hold the underlying for long periods of time, we immediately discarded any highly-leveraged ETFs (i.e. UltraShort anything.)  We worked through the published listings on the site, doing research on the underlying securities themselves (using Google, TradeKing, TD Ameritrade, etc.), and eventually identified UNG (an ETF based on US natural gas futures) as something we felt comfortable holding for a period of months. (This research was done on the weekend prior to the market being open.)  Our thinking was that natural gas prices seem unsustainably low right now given the growing focus on clean fuels.  Also, with the fund near its 52wk low and cooler weather coming in a few months, we believe there is some natural resistance to further drops in price.

Then, near market open, we researched the call option chain for UNG using TradeKing’s screen for covered calls, and found that a near term (July 2009) call option (symbol UNY GM) with a $13 strike seemed like a fairly good balance between the return if the option was exercised (3.9% in about two weeks when transaction costs included, or a 170% APY) and if it was not exercised (4.5% again including transaction costs, or 217% APY) vs. the risk of having to hold the underlying longer than July expiration.  These return figures use the quotes from Friday’s closing (you can see them on the ETF Covered Calls site btw) and assume TradeKing’s $4.95/limit transaction fee, plus an additional $0.65/option contract fee.

We entered our buy-write order using TradeKing’s specific order entry screen for covered calls (the link works for those with a TradeKing login.)  Here you can set a “net debit” for your transaction, which is an easy way to ensure the two legs of your covered call trade don’t execute separately and don’t use an unexpected amount of your cash available to trade.   A word of caution about this though (also known as hindsight in this case!), this method does not place each leg via its own limit order, it just establishes a limit on the net debit to your cash.  That means that if the option’s quote drops suddenly, your order may still get executed if there is a similar or greater drop in the underlying’s quote.  This can severly change your return calculations!  In our case, we had (mistakenly) entered our order prior to market open with a net debit of $12.36 ($13.11 – $0.75), and thus were basing our calcs on old data.  Our order immediately got filled at market open with UNY GM at $0.34 because UNG had simultaneously dropped to $12.33 (an actual net debit of $11.91, or $12.10 after including transaction costs).  This changed our return calcs to 9.9% if called and 2.29% if not called.  While that first number looks nice, we now know it is a bit less likely that our $13 strike will get met so we’re more likely to have to hold UNG past July expiry — not totally terrible, but we were hoping to return to cash at July expiry on this first transaction.  And our immediate return, that is the yield if not called (i.e. net cash received divided by total investment cost of the underlying)  has been almost cut in half to 2.3% (which corresponds to a much lower 80.3% APY).   Remind me in the future to enter orders when the market is open!

BTW, it wasn’t until after the fact that we learned about UNG’s share limitation issues.  If I’m understanding correctly, it seems that demand for shares of the fund may slightly help it trade above NAV.  Other than that, I’m not sure what effect it will have on us.

Additional note: For future trades, we’ll probably look at covered calls using either ETFs or  large cap company stocks that pay dividends during the period until option expiry.  This should help improve the total return by capturing dividends.

Tags: ETFs · Options · Trades

12 responses so far ↓

  1. 1 davmp // 2009.07.14 at 5:58 am

    Well, with only 4 days to expiry, and yesterday’s close of $12.03, it certainly doesn’t look like the call we sold will be exercised. Looks like we’ll be selling a new call for August expiration next week. UNY HM (Aug09 $13 call) ended yesterday with a bid of $0.65, we’ll see how well that holds up after this weekend.

  2. 2 davmp // 2009.07.15 at 11:13 pm

    Just saw this article, Natural Gas ETF ‘Taxed’ By Delay, which claims that UNG is trading at a 2.56% premium to the NAV. Glad to see that I at least got that part right. I am starting to wonder how much these warnings from the press to stay away from buying UNG will effect things though.

  3. 3 Rich // 2009.07.17 at 2:53 pm

    So did you get assigned today? Looks like UNG closed above $13.

  4. 4 davmp // 2009.07.17 at 6:04 pm

    @Rich: TradeKing doesn’t currently show the call being assigned, but I think it would be freaky if it didn’t since shares closed $0.16 above the strike ($13). Perhaps it is just that TradeKing doesn’t show assignments until Saturday? If I’m understanding their site docs correctly, they won’t show the underlying shares removed until Sunday either.

  5. 5 Rich // 2009.07.18 at 3:40 pm

    What is TradeKing’s policy on assignment? Most brokers now have assignment if it is $0.01 within strike price but I’m not familiar with TradeKing.

  6. 6 davmp // 2009.07.18 at 5:20 pm

    @Rich: Automatic assignment when in the money by just $0.01 is also TradeKing’s policy. However, I was under the impression that only applies to options that you’ve BTO (bought to open) and therefore control the right to exercise. In this case, I sold a call so someone else holds that right.

    I just checked my TradeKing account, and interestingly they are showing my $13 UNY GM call as being expired instead of exercised. I can only theorize as to why. Possibly someone thought the rise above $13 didn’t reflect “real” value and was simply due to a temporary situation related to the inability to issue new shares? Possibly they got scared away from owning UNG due to the news stories about possible regulation changes? Either way, I now have 100 shares of UNG that I can either STC (sell to close) for an additional profit (assuming the price stays above $13 when the market opens on Monday), or sell a new covered call against.

    As of right now, it looks like UNG is up to $13.18 in after-market trading. Assuming I can close out my position for that, it would make the round-trip profit total $103.49 (after all commissions) on a capital investment of $1,237.95, a return of 8.36%. Considering that this position is only over a 13 day period (IF it could be traded after-hours on the weekend) the annualized yield is 853%! Of course, there’s no guarantee I can get transacted in after-market trading. I’ve never tried such a thing before. And I’m also assuming a transaction fee of $4.95 which may or may not be correct — I can’t find anything on TradeKing’s site about after-hours commissions. If the sale doesn’t happen until Monday, but still occurs at $13.18, then the holding period is 15 days which drops the annualized yield to 605%.

    On the other hand, I could sell a new call against the shares. Selling an Aug09 $13 call would capture an additional premium of $99.39 (using Friday’s closing bid and TK’s commission structure), and thus generate a cumulative static return of $127.78 (after all commissions), or 10.3%. The return if called in August would be $184.88 (after all comissions), or 14.9%. However, the annualized yield drops to 197% due to a longer holding period of 47 days. There is no dividend benefit to holding UNG for this longer term so it seems the real question is whether we could do something better after reverting to cash.

    While I do believe gas prices will rise as we approach cooler months, I am somewhat nervous about the possibility of regulatory changes and the sort of impact it could have on UNG. So, given my analysis above, I’m going to try placing an after-hours limit sell order. We’ll see what happens.

  7. 7 davmp // 2009.07.18 at 6:13 pm

    Since I’m a bit bullish on UNG, I’m doing research on selling UNY HN (Aug09 $14) which had a closing bid on Friday of $0.65. Or even UNE HO (Aug09 $15) which closed at $0.40 on Friday. Both of these had a volume over 12,000 and significant open interest (18,000+)

    For UNY HN, the static return would be $87.78 which is 7.09%. The return if called would be $244.88 (19.8%) for an annualized yield of 306%.
    For UNE HO, the static return would be $62.78 which is 5.07%. The return if called would be $319.88 (25.8%) for an annualized yield of 496%.

    What about a further out call? Say UNE JO (Oct09 $15) which had a closing bid on Friday of $1.00. The static return would be $122.78 (9.92%) and the return if called would be $379.91 (30.7%) for an annualized yield of 158% due to a much longer holding period of 103 days.

    Am I really that bullish??? And how different will Monday’s bids be from Friday’s closes given that it was expiry weekend? I’ll definitely need to run all these scenarios again if I don’t just simply STC the position.

  8. 8 Rich // 2009.07.18 at 8:53 pm

    Interesting…I’m not bullish on oil or gas, I think oil might get hammered down to $30/barrel and gas may go down to $2.5 mBTU and it’s a scary prospect. I’m trying to find a good spot to unwind OIH but I may sell Jan 10 $110 calls and wait it out another six months. Good luck and happy hunting!

  9. 9 davmp // 2009.07.19 at 6:39 am

    @Rich: I’ve been watching, with great interest, your adventures in OIH. While I’m also thinking we’re facing drops in oil prices, I’ve somehow convinced myself that natural gas is in a different boat for reasons already mentioned. That being said, I am nervous about the possible effects of changing regulations on UNG so I’m seriously leaning toward STC. And indeed, that is what I tried to do after posting comment #6 above. However, if there is any weekend off-hour trading going on, TradeKing won’t let me participate as their “Extra Hours” tab has been showing a closed sign even though it doesn’t mention being limited to Mon thru Fri. I guess my inexperience is showing here.

    Which brings me to a second point, I want to be clear that my “remedial” tone in the comments above is not directed at you, but is instead intended to better educate myself (and my wife). I also have a hope that someone with more experience (hint, hint) will read my stuff and have an obvious place to point out if and where I’ve gone wrong.

  10. 10 davmp // 2009.07.19 at 4:56 pm

    I’ve got to say, at this point I’m not super-thrilled with TradeKing. On Saturday, they showed my UNY GM as “Expired” on the Activity webpage for the account. But at 9:22 am CDT this morning (Sunday), they sent an e-mail notifying me that the option had been assigned. And indeed when I check the website, the Activity log shows the underlying UNG as being sold for the strike of $13 on 2009.07.20 (tomorrow). They no longer show any info about the option itself though. I wouldn’t be unhappy if they hadn’t shown the option as expired first! Is this the way other brokerages handle options at expiration??

    Anyway, now that the round-trip is completed and I’m back to cash, I can do a final analysis (all dollar numbers INCLUDE the relevant commissions, which is why I go into more precision than a single cent):

    Critical Dates
    2009.07.06: BTO 100 UNG @ $12.3795
    2009.07.06: STO 1 UNY GM @ $0.2839
    2009.07.20: STC 100 UNG @ $12.9501

    Summary
    Days position held: 15
    Capital investment: $1237.95
    Income received: $85.45
    Static return: 6.90%
    Annualized yield: 407%

  11. 11 Rich // 2009.07.19 at 7:58 pm

    So you were assigned. Well that’s interesting how TradeKing does/does not notify you of what’s happening. The best notification system I’ve seen is on e-trade but with their capitalization issues I’m not exactly ready to endorse them. If you don’t mind me asking, how much was the assignment fee?

    Other brokerage accounts I have don’t seem to do a better job than TradeKing but I’ve never seen one say “expired” then go back and say “assigned.” That’s a new one. To be fair, on Monday you should know exactly what has or has not transpired with the trade. UNG has always been a bit quirky and I only had limited (profitable) trades with that ETF. Over the last couple of years I’ve stayed away from UNG and USO etfs, they seem to be in perpetual contango.

    As for the other stuff, I certainly don’t know everything there is to know about options and I’ll try to stop by and check periodically but I have a very full calendar and it seems to get more full by the day. I’m currently on my third vacation for the summer, I’ll hopefully be back home soon.

  12. 12 davmp // 2009.07.19 at 8:46 pm

    @Rich: I don’t mind you asking at all. TradeKing isn’t showing an explicit assignment fee in my account’s activity log (yet?). They’re just showing the standard sales commission of $4.95 with an additional $0.04 regulatory levy fee. Said another way, my net cash out on the sale at $13.00 is $1295.01.

    I’m thankful for any advice or help you can offer. Enjoy the rest of your vacation. And good luck with the job situation!

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