Investors know that one way to generate income from a conservatively managed portfolio of high-quality stocks is to write covered calls against securities in the portfolio. This generates premium income at the expense of foregone capital gains, in the event the shares ended up rising sharply in price. Investors who need a primer on this can go here.
Potential option writers often ask if it is better to write the calls at a "strike price" at the money, or just slightly out of the money. The latter strategy allows the stockholder to capture at least some of the capital gains, but the premium income is reduced since the options would be written (sold) at a lower price.
Thanks to the creativity and diversity of modern financial markets, we can answer this question in great detail. We can look closely at the performance of two buy/write ETFs:
- PowerShares S&P 500 BuyWrite Portfolio (NYSEARCA:PBP), and
- Horizons S&P 500 Covered Call ETF (NYSEARCA:HSPX).
Both of these ETFS write covered calls against their holdings in the S&P 500. According to ETFdb.com, the betas (risk) and holdings of the two ETFS are almost identical. (This makes sense since they are, after all, S&P 500-tracking ETFs.)
The only difference is that PBP writes their calls at, or slightly out of the money; whereas the HSPX prospectus specifies out of the money calls.
Therefore, we can compare the results of the two strategies.
HSPX has only been trading since last June: let's compare how they did in the 2nd half of last year.
My readers know that I use charts to make comparisons clear. In the case of covered call writing, however, where premium income is such an important part of total return, charts only tell part of the story. In the analyses below, I will add in the dividend/premium income to the capital gain (or loss) in order to compare the performance of the two ETFS.
Let's look at PBP first.
The hashed line shows PBP and the blue line shows, for comparison, the S&P 500 Index. The $ signs are dividend payments, which total $1.04. Over this time span, the price rose from $19.91 to about $20.17; this small $0.26 capital gain plus the premium income totaled $1.30, for a total return of about 6.5% since late June of last year. Notice the chart shows only the capital gain, about 1%.
Turning to HSPX, we have:
Dividend payments total $1.12 (notice they were made more frequently, but were often smaller); and the share price rose from $39.80 to $42.76. The total gain was $1.12 + $2.96, or roughly 10.3% total return. (The chart shows about a 7% capital gain).
Notice we see pretty much what we expected:
- the "at the money" portfolio, PBP, showed primarily premium income as its source of total return; and
- the "slightly out of the money" portfolio, HPSX, showed primarily capital gains.
For investors who wish to supplement their diversified holdings with some premium and dividend income, HPSX appears to be the superior choice. PBP appears to have left too much capital gain "on the table"; that is the good stocks got called away and the poor performers in the S&P 500 remained in their coffers.
How would these two portfolios compare in flat or declining markets? So far, 2014 looks like we might see plenty of the latter two scenarios. In a few months, I will update this article to see how the two ETFs stand against one another.
Disclosure: I am long XLK, IHI, XLV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Call writing is a conservative strategy investors can use to generate premium income.