Using Options on Index ETF's to Generate Monthly Income

In this post I will be writing about an option strategy known as the Diagonal Call Spread Option Strategy. To understand this post you'll need somewhat of a background in stock options. To learn more about options and, how options can help protect your portfolio, and allow you to speculate with less money up front; check out my book here.

A Diagonal Spread option strategy is very similar to the Bull Call Spread option strategy, except that it uses different option expiration dates instead of the same. This strategy is a great way to generate monthly income off the ETF, regardless of what the fund does. I will be using three very popular ETF's for my examples, but similar strategies can be used on any stock that offers stock options. The ETF's are the: Diamonds Trust (DOW), Series 1 (DIA), PowerShares QQQ Trust (NASDAQ), Series 1 (QQQQ), and SPDR S&P 500 (SPY).

All data as of market close Friday July 24, 2009.

Income Generating Strategy #1: Purchase the in the money DIA 50 strike January leap 2011 call option, and sell the 93 strike August 2009 call option against it. The initial cost of the January leap 50 call option is $41.07 per share. Writing the August option out would give you cash of $1.03 per share or 2.5% of your initial investment.

• If the ETF is assigned at the August options expiration, the total return is 7.21% (in less than 30 days).
  
• If the position is not assigned (called out) you will have profited 100% of the premium received ($1.03 per share or 2.5%), and will be able to write the option out again for a future expiration generating additional income. You will be able to write options out on this ETF on a monthly basis until January 2011 (546 days).
  

Income Generating Strategy #2: Purchase the in the money QQQQ 20 strike January leap 2011 call option, and sell the 41 strike August 2009 call option against it. The initial cost of the January leap 20 call option is $19.51 per share. The August 41 Call option is currently trading for $0.35 per share. Writing this option out would give you cash of $0.35 per share or 1.8% of your initial investment.

• If the ETF is assigned at the August options expiration the total return is 9.43% (in less than 30 days).
  
• If the position is not assigned (called out) you will have profited 100% of the premium received ($0.35 per share or 1.8%), and will be able to write the option out again for a future expiration generating additional income. You will be able to write options out on this ETF on a monthly basis until January 2011 (546 days).

Income Generating Strategy #3: Purchase the in the money SPY 50 strike December leap 2011 call option, and sell the 100 strike August 2009 call option against it. The initial cost of the December leap 50 call option is 48.58 per share. The August 100 Call option is currently trading at $1.49 per share. Writing this option out would give you cash of $1.49 per share or 3.1% of your initial investment.

• If the ETF is assigned at the August options expiration the total return is 7.06% (in less than 30 days).
  
• If the position is not assigned (called out) you will have profited 100% of the premium received ($1.49 per share or 3.1%), and will be able to write the option out again for a future expiration generating additional income. You will be able to write options out on this ETF on a monthly basis until December 2011 (876 days).

When I open diagonal option call spread positions, I like to purchase contracts which have the longest time until expiration, and like to write the contracts with the closest time until expiration against it (given roughly a 5% return or greater if assigned). If the stock is not assigned at expiration, I simply write it out for a similar strike price for the following month. It is like receiving monthly dividends.

These are just examples and are not recommendations to buy or sell any security; if you're more bullish/bearish, you’ll want to adjust the strike price and expiration accordingly.

I've been using this strategy to sell near the money calls on my leap stock options for the short term, and find it to be a great source of generating income for my portfolio. Using these ETF's versus stocks, is a much safer strategy, but won't return as much either.

If I want to be long a stock I simply purchase deeper in the money leap options, and write call options for the near term expiration against them. It is a great way to be in the stock, receive income (premiums) month after month (that's if it's not assigned), while returning a profit on the position if the stock happens to be assigned. The downside however is you limit your upside gain for the stock.

In the past 5 years, the volume of option contracts traded has exploded according to the Chicago Board Options Exchange [CBOE]. The reason being is that more and more investor's are finding options to be a good source of income, a great way to hedge their portfolios, and a way to speculate with less cash up front. To see a chart showing options volume over the last 5 years, and to learn more about options in general click here.


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