Converting High Volatility ETFs to Conservative Cash-Generating Positions: A Real-Life Example with Global X Lithium & Battery Tech ETF (NYSE: LIT) – July 6, 2021
The covered call writing and put-selling premiums we receive are directly related to the implied volatility (IV) of the underlying securities. This is true of both stocks and exchange-traded funds (ETFs). How do we manage elite-performing securities that generate extremely high returns for near-the-money strikes? In other words, can we use these securities and mitigate the risk of the high IV? Of course, the answer is “yes” or I wouldn’t be writing this article. On January 18, 2021, Barry R. wrote me an email:
Alan,
I am evaluating new stock purchases to sell calls on.
The list is limited because of earnings reports. I evaluated ETFs.
ICLN strike 30 has ROO 6.8%.
PBW strike 120 has ROO 7.8%.
LIT strike 68 has ROO 6.4%.
YOLO strike 22 has ROO 9.1%.
These are all for exp 2/19.
This doesn’t make sense that the ROO is so high.
What am I missing?
Barry R
The ETFs Barry was alluding to were taken from our premium member ETF Report dated 1/13/2021.
Premium member ETF Report showing the IV of the 4 ETFs
Note that the IV of the 4 ETFs range from 56.92 to 73.56 (brown cells) while that of the S&P 500 is 18.35 (blue arrow).
Mitigating risk with in-the-money call strikes
Let’s turn to the 1-month option-chain for LIT ($68.30):
With LIT trading at $68.30, we will look to target a deep in-the-money strike that will generate a significant 1-month initial time-value return while simultaneously offering compelling downside protection of that time-value profit and lowering the breakeven to a comfortable level. In this case, we will calculate the returns for the $61.00 strike.
LIT calculations using the Ellman Calculator
Using the $61.00 deep in-the-money strike still generated a 1-month initial time-value return of 2.3% (yellow cell) with downside protection of 10.7% of that time-value profit (brown cell). The breakeven is lowered from $68.30 to $59.60.
Discussion
Mastering the 3-required skills for option-selling will give us the ability to convert potentially risky trades to more defensive positions while still generating significant time-value returns. In this case with LIT, we used a deep in-the-money strike to position ourselves favorably in both areas.
Author: Alan Ellman