Daily Gains Letter

Uncertain About the Stock Market’s Direction? Then Look at This ETF

By for Daily Gains Letter | Feb 11, 2013

DL_Feb_11_2013_MoeAfter the financial crisis of 2008, investors have been hesitant to go back to the stock markets. The volatility in the key stock indices reached its all-time high. For example, the Dow Jones Industrial Average fell below the 7,000 mark in 2009, after it traded well above 14,000 in mid-2007. Now it’s close to where it was back in 2007.

Unfortunately, volatility did take a toll on the savings of millions of Americans involved in the stock market. Though key stock indices declined little more than 50%, there were companies that went out of business and left investors with nothing.

With all this, and an influx of mixed data now available, many investors are still unsure about the direction the stock markets might take, and which sectors and industries are going to perform better. Will the markets trend higher? Lower? Are they just going to trade sideways?

If you are an investor who believes stock markets are going to sideways, here is something you can consider. An exchange-traded fund (ETF) called the PowerShares S&P 500 BuyWrite (NYSEArca/PBP).

What this ETF essentially does is follow the Chicago Board Options Exchange’s (CBOE) S&P 500 BuyWrite Index. It usually invests in 90% of the companies that make up the index and writes covered calls against them. (Source: PowerShares web site, last accessed February 6, 2013.)

In other words, this ETF buys shares in the S&P 500 companies, and then sells call options against them. Through this strategy, the fund can make income on a stock while holding it—a strategy that’s considered one of the best in a sideways market. This investment strategy is called a covered call option strategy.

At the most basic level, the covered call option strategy is simply selling a right to sell your stock in the future at a certain price—selling/writing a call option. In return, you receive a fee, which the buyer pays to buy the right.

Advantages of Owning PowerShares S&P 500 BuyWrite

One of the biggest advantages investors can possibly have by owning this ETF is the ability to employ a covered call strategy on a number of stocks at the same time.

Consider this scenario: Say you only have $5,000 in your portfolio, and you want to earn income from it. You can buy a stock worth $50.00 and only get 100 shares. But, if the call option for this stock sells for $1.00 each, then every time you use covered call strategy, you will receive only $100.00.

At the same time, your risk will be much higher, because your entire portfolio will be based on one stock. If it goes down in value by more than $1.00, your losses will start to add up. Simply put: your risks are much higher.

With this ETF, you can get much more market exposure and greater diversification. PowerShares S&P 500 BuyWrite buys stocks of companies in major sectors, including utilities, consumer discretionary, information technology, industrials, and financials.

In addition to diversification, the fund also provides its investors with quarterly dividends. Since its inception in 2008, the fund has paid a dividend every quarter, increasing from $0.05 to $0.14 per share in the most recent quarter—that’s an increase of 180%.

Some Drawbacks to Consider

With all the advantages of holding this ETF, investors must consider its drawbacks as well. The covered call strategy that the fund uses has some limitations, and it may not be a great strategy in the case that the market starts to trend higher or lower.

For instance, when you sell a covered call, it’s true that you receive an income from selling the contract right away; but you are also obligated to sell your shares if the prices reach the agreement prices. In other words, with covered calls, your gains are limited.

As for losses, they can only be minimized to the amount of premium you receive by selling the call options. For example, if you own a stock that you purchased for $50.00 and you sold call options for $50.00, if the stock price goes below $49.00, you will be have a loss.

Keep in mind, PowerShares S&P 500 BuyWrite might not be for every investor. It is considered to be one of those alternative strategies ETFs that don’t do the conventional “buy” or “sell” commodities, stocks, and futures.

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