Emerging Markets Covered Calls

While developed nations, such as the U.S. and most Western European countries, have been clawing their way out of a recession, emerging markets have been enjoying significant economic growth, making investments in these markets attractive. However, coupled with the characteristic high growth rates in the gross domestic product (GDP) of these nations is usually considerable uncertainty in their political and/or economic environments. Risk. Which makes diversification and liquidity even more important factors to consider when investing in the stocks of these countries. Most individual investors lack the kind of resources necessary to diversify their emerging markets holdings adequately by investing in single company securities. A great alte ative for them is to invest in an exchange-traded fund (ETF) that invests in emerging markets. ETFs trade just like individual stocks, which means investors can elect to use a "buy-write" strategy with them, generating more portfolio income through the premiums they receive on the calls that they write. There are a number of emerging market ETFs from which to choose. You can invest in an ETF that diversifies across a number of emerging markets or one that invests primarily in one specific area-such as Latin America—or even in one that invests in a single country, as does the iShares MSCI Brazil Index exchange-traded fund (EWZ). Regardless, the same rules apply to emerging market covered calls that apply to writing covered calls in general. One important consideration is liquidity. Remember that liquidity in the ETF can be gauged by its average trading volume and that a more active and liquid ETF will have a more active options market with smaller spreads and better fills. As an example, consider the following three emerging market ETFs: iShares MSCI Emerging Markets Index (EEM), Vanguard Emerging Markets (VWO), and BLDRS Emerging Markets 50 ADR Index (ADRE). The 3-month average daily trading volume for EEM, as reported on the finance.yahoo.com website, is 56,144,400; for VWO, it is 13,104,200; and for ADRE, it is 145,632. On October 22, 2010, EEM was selling for $46.00, and a November 2010 at-the-money call on the ETF was selling for $1.26. Open interest was 82,368. On that same date, VWO was selling for $46.67. A November 2010 call that was just slightly out- of- the-money was selling for a price similar to the EEM call--$1.20—but its open interest was only 404 contracts. The least actively traded of the three, ADRE, doesn't even have calls with a November expiration. The only expiration date provided is December 2010. ADRE shares trade in the same price range as the other two—$45.83 on October 22nd. The premium on the slightly out-of-the-money December call is $4.90. Compared to the other two, this may look attractive, but remember part of the reason for the higher premium is that there is more time value on the ADRE call. And it is significantly less liquidity. Open interest was only 17 contracts. Less liquidity = higher risk = higher transactions costs should you ever need to modify the covered call position prior to expiration.