DIA/DXD Hedged Covered Call Paper Trade

One of the members of the JustCoveredCalls Yahoo Group started a discussion on an interesting covered call strategy. The strategy involves using a hedged position in two ETF's, DIA, Diamonds Trust, which tracks the performance of the Dow Jones Industrial Average index, and DXD, UltraShort Dow30 ProShares, which tracks twice the inverse of the daily performance of the Dow Jones Industrial Average index and trades at about half the price of DIA.

The purpose of trading the DIA/DXD pair is to hedge the position so that no matter which way the market goes the net change for this pair will be as close to zero as possible.

Let's take a simple example and say that DIA is at $100 and DXD is at $50. Now, if DIA goes down by $10 or -10%, in order for DXD to hedge this position it must go up by $10 or +20%. So, because DXD is half the price of DIA, it must to go up/down by twice the percentage change of DIA in order to change by the same amount to hedge the position.

So, you might ask, how can we make money if the returns of DIA/DXD offset each other? Well, one answer is that both DIA/DXD pay a nice dividend, 2.30%/3.46% respectively, and the other answer is by selling covered calls on both positions each month. The stock positions should offset, but we get to keep the dividends and the option premiums.

In order to test this theory I've started the following paper trade. I bought 100 shares each of DIA/DXD and sold strikes that were 5%/10% OTM. Why 5%/10% OTM? Well, one reason is that I don't want these positions called away. This is going to be a perpetual position. The other reason is because 5%/10% represents the maximum up/down monthly percent change in DIA/DXD since the inception of DXD on 7/13/06. The goal is to have DIA/DXD close below their respective strike prices at expiration so the entire option premium is kept.

The following is the trade information, including IB commissions, using today's closing prices:

DIA Position

12-Mar-08 - Initial Stock Position - BTO 100 DIA @ 121.41
12-Mar-08 - Initial Call Option - STO 1 Apr08 127.00 Call @ 1.16

Stock Investment: $12,141.00
Income Generated: $116.00
Percent Income Generated: 0.96%
Annualized Income Generated: 9.43%
Days Held: 37 days

DXD Position

12-Mar-08 - Initial Stock Position - BTO 100 DXD @ 58.86
12-Mar-08 - Initial Call Option - STO 1 Apr08 63.00 Call @ 1.44

Stock Investment: $5,866.00
Income Generated: $144.00
Percent Income Generated: 2.45%
Annualized Income Generated: 24.13%
Days Held: 37 days

Combined Position

Stock Investment: $18,027.00
Income Generated: $260.00
Percent Income Generated: 1.44%
Annualized Income Generated: 14.23%
Days Held: 37 days

I didn't include the dividends in these returns so they should actually be a bit better. I also didn't show the return if called, since the intention is to not have either side called away.

I'll continue this trade for a few months to see how it performs and will post the adjustments and results.