For the sake of simplicity, the examples below do not take transaction costs (commissions and other fees) into account.
Remember the old Certs commercial? Two mints in one? In today’s market, sometimes a trader is also an investor. And as an investor, you may hold some core positions longer term, maybe even for years (gasp). Nothing wrong with that. For a lot of investors, core positions are mutual funds.
Perhaps you’ve tried options strategies with the intent of generating income or reducing the cost basis of core positions. If they’re comprised of individual stocks, you might sell calls against them. For example, if your core position was long shares in AAPL, GM, and XOM, you could sell calls in AAPL, GM, and XOM, respectively. This, of course, is a covered call strategy, which limits the upside potential of the underlying stock positions in exchange for selling the right to call your shares away.
Unfortunately, options aren’t traded on mutual funds. And mutual funds don’t always move higher. So since selling calls against mutual funds isn’t possible, how can you generate income on them?
When Selling Calls Is Not An Option
Many big mutual funds have high “positive correlations” to big equity indices like the S&P 500, NASDAQ 100, or Russell 2000—so when the index price goes up, the mutual fund price goes up, too. And when the index goes down, the fund price goes down, too. Which makes sense. Because most big mutual funds contain many of the same stocks in the larger indices, particularly if the fund’s objective is to track a particular index.
Conveniently, there are options on the big indices whose symbols are SPX (S&P 500), NDX (NASDAQ 100), and RUT (Russell 2000). Since selling a call on an index like SPX isn’t “covered,” if you’re a qualified options trader, you may consider selling out-of-the-money (OTM) call verticals in those index options, in combination with your mutual fund, to mimic what you do when you sell calls against stocks.
With OTM short call verticals on SPX, you have defined risk equal to the difference between the long and short strikes, minus the credit received. Therefore, the cash requirement can be low. And if your fund is in an appropriately approved IRA, you can typically sell call verticals. There are generally three steps to this process:
1. Check the correlation between your fund and the index;
2. Determine the quantity of call spreads to sell;
3. Choose where to place the call spread.
Correlation reveals the strength of the price relationship between two symbols (e.g., an index and a mutual fund) for a certain amount of time. Explore the correlation by firing up the Charts tab in the thinkorswim® trading platform by TD Ameritrade, and refer to Figure 1.
First, go to Charts and type in the fund symbol, minus the symbol of the index it’s most closely tracking—such as SPX (if the fund tracks the S&P 500). For example, “MNKYX SPX”.
Next, go to the Edit Studies menu and select “Pair Correlation” from the studies list. This adds a study to the chart that shows the correlation between your two symbols, MNKYX and SPX.
The default amount of time for the Pair Correlation study is 10 days, which you can edit. The strongest correlations are high no matter what timeframe you look at.
Correlation is measured between +1 (the fund and the SPX always move up and down together), and -1 (the fund and the SPX always move in opposite directions). A correlation of +1.00 is strong. But I would consider anything above 0.80 as a high correlation. For example, if you see that the correlation between your fund and the SPX is +0.99 for 10 days, but only +0.50 for 30 days, the correlation may not be stable or strong, and you may not want to be mixing SPX options with that fund. Maybe try another index, like NDX or RUT. But if the correlation is +0.99 for both 10 days and 30 days, the correlation is more reliable, and that index might be considered a good candidate in which to sell call spreads.
Now, it's possible to lose money on both the mutual fund and short index call spread if the correlation turns negative and the fund price drops while the index rises. As long as the fund holds similar stocks to those in the index, the correlation should stay positive. But be aware there are no guarantees with this strategy. (Keep in mind also that spreads strategies can entail substantial transaction costs, including multiple commissions, which may impact potential returns.)
Determine the Quantity of Spreads
Once you’ve identified the index correlated to your fund, how many call spreads do you need to sell? For that, determine how many SPX deltas your fund position represents, which can be found under the Analyze tab of thinkorswim.
Type in the fund’s symbol on the Analyze page. If the fund is held in your TD Ameritrade account, you’ll see it in the Positions and Simulated Trades section. If not, you can enter a simulated trade that’s the same as your actual position by clicking on the “Ask” field on the Add Simulated Trades sub-tab. Even though the Ask price is “N/A,” you can still create a simulated long position in the fund.
Figure 2 shows a simulation of being long 5,000 shares of the fund. To determine the number of spreads to sell:
- Enter the fund symbol in the symbol box at top. Change the price in the Positions and Simulated Trades section to the last price of the fund.
- In the Price Slices section, you’ll see that the fund position has 5,000 deltas. With 5,000 shares of the fund, if the price of the fund goes up $1, the value of the fund position will rise by $5,000. Now, click on “Single Symbol,” and select “Portfolio, Beta-Weighted.” Then click the little lightning bolt icon to the right of the drop-down and select “Fast Beta.”
- Type in any symbol, such as SPX, in the symbol field, to beta weight against that stock. In the case of our example in Figure 2, watch how the deltas of the fund position go in this scenario from 5,000 to 69. Beta weighting the fund’s deltas tells you that if the SPX goes up or down $1, the fund position could theoretically make or lose $69. If the SPX goes up or down $20, the fund position could theoretically make or lose $1,380.
To determine how many short OTM call spreads you’ll need, let’s assume the max risk of a single, short SPX call spread is $500. If you sold three of those call spreads and the market goes up, you could potentially lose a max of $1,500. Of course, it depends on how far OTM you sell that call spread (we’ll consider that next). But if you sell call spreads less than 10 points OTM, and the SPX goes up 20 points, you would lose $1,500 and your fund would only theoretically make $1,380. If the market goes even higher, the loss on the three short call spreads is limited to $1,500, and your fund might continue to make money.
Choose Where To Place the Call Spread
Selling a nearer OTM call spread will give you a larger credit, but it takes a smaller move in the index for it to lose money. Selling a further OTM call spread takes in a smaller credit, but gives the index more room to move higher before the trade loses money. And you take in more credit when you choose a call option spread in a further expiration, but that gives the index more time to move higher and create a loss.
- Start by choosing an expiration with about 60 days. That’s where the options still have relatively high extrinsic value, and their time decay is slowly starting to increase.
- Then look for the call spread where the short and long strikes are adjacent to each other (e.g., a short SPX 2010 call and long SPX 2015 call) that nets a credit near one-third of the width of the strikes (about $1.65 for a 5-point spread). That makes the max loss of the 5-point spread $335.
- Now determine how many points the SPX would have to rally to hit that long strike price and create the max loss. Multiply the beta-weighted delta of your fund position by that number of SPX points to see how much it would theoretically make. Does the profit on the fund offset the loss of the vertical? If not, maybe move the short call vertical to a higher strike. If it does, consider moving the vertical to a lower strike to collect a larger credit.
Overall, be patient with this strategy. The goal is for the credits from the short index call verticals to slowly accumulate and generate extra income, and/or indirectly reduce the fund’s cost basis. The credit you receive for selling the call spread is the amount your fund’s cost basis decreases with this strategy. Conversely, any loss on the verticals would increase it.
Finally, you’ll need buying power in your account to cover the margin requirement for the short call spreads. If all you have is the mutual fund, you’ll need to deposit cash. Now, go take a look at your mutual funds with a whole new perspective.