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Thursday, January 26, 2012

Establish ProShares UltraShort S&P 500 ETF Covered Calls

A new covered calls position was established today in the Covered Calls Advisor Portfolio(CCAP) with the purchase of ProShares UltraShort S&P 500 ETF (Symbol SDS) covered calls as follows:

Established ProShares UltraShort S&P 500 ETF (SDS) Covered Calls for Feb2012:
01/26/2012 Bought 1,000 SDS @ $17.07
01/26/2012 Sold 10 SDS Feb2012 $18.00 Calls @ $.29
Note: the price of SDS was $17.19 when the options were sold.

Based on Relative Strength indicators, the S&P 500 seems overbought at this time. So a long position (but only 5% of the total value of the Covered Calls Advisor Portfolio) was established in this inverse ETF (SDS) as a hedge against the likelihood of a short-term (Feb2012 expiration) market decline from current levels.

Some readers might ask: "Why establish an out-of-the-money position in an inverse ETF instead of simply an in-the-money position in a direct investment (such as SPY)?" My answer is: "An out-of-the-money position in the inverse SDS ETF enables the possibility of capital appreciation in the underlying ETF if the overall stock market now begins to trend lower. This establishes the possibility of a substantially higher return-on-investment result than could be achieved from an in-the-money SPY position (since in-the-money covered calls positions eliminate the possibility of capital appreciation in the underlying equity) .

Although there are unlimited outcomes, two possible overall performance results(including commissions) for the ProShares UltraShort S&P 500 ETF (SDS) transactions would be as follows:
Stock Purchase Cost: $17,078.95
= ($17.07*1,000+$8.95 commission)

Net Profit:
(a) Options Income: +$273.55
= ($.29*1,000 shares) - $16.45 commissions
(b) Dividend Income: +$0.00
(c) Capital Appreciation (If price of SDS is unchanged at $17.07): -$8.95
= ($17.07-$17.07)*1,000 - $8.95 commissions
(c) Capital Appreciation (If SDS above $18.00 at Feb2012 expiration): +$921.05
+($18.00-$17.07)*1,000 - $8.95 commissions

Total Net Profit(If SDS unchanged at $17.07): +$264.60
= (+$273.55 +$0.00 -$8.95)
Total Net Profit(If SDS above $18.00 at Feb2012 options expiration): +$1,194.60
= (+$273.55 +$0.00 +$921.05)

1. Absolute Return if Unchanged at $17.07: +1.5%
= +$264.60/$17,078.95
Annualized Return If Unchanged (ARIU): +24.6%
= (+$264.60/$17,078.95)*(365/23 days)

2. Absolute Return (If SDS above $18.00 at Feb2012 options expiration): +7.0%
= +$1,194.60/$17,078.95
Annualized Return (If SDS above $18.00 at expiration): +111.0%
= (+$1,194.60/$17,078.95)*(365/23 days)

The downside breakeven price at expiration is at $16.78 ($17.07 - $.29). Using the Black-Scholes Options Pricing Model in the Schwab Hypothetical Options Pricing calculator, the resulting probability of making a profit (if held until Feb2012 options expiration) for this ProShares UltraShort S&P 500 ETF covered calls position is 59.6%. This compares with a probability of profit of 51.7% for a buy-and-hold of SDS over the same time period.

The upside crossover price at expiration is $18.29 ($18.00 + $.29).
This is the price above which it would have been more profitable to simply buy-and-hold SDS until Feb 17, 2012 (the Feb2012 options expiration date) rather than holding the covered calls position. The Options Pricing Model indicates that the probability that this will occur is 22.2%.

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