- The low-yield environment has left income investors hungry for yield.
- With the stock market at all-time high, this environment is ripe for profiting by writing covered calls.
- Writing individual covered calls can be complex and expensive. However, this article discusses ETFs available to take advantage of this strategy.
- Covered call ETFs underperform in rapidly rising bull markets, but do great in flat or declining markets.
The stock market continues to linger close to the all-time high while the interest rates continue to hold at an all-time low. There is still no clear indication from the Fed on when the interest rates will rise - leaving risk-averse investors with paltry returns on cash and bond holdings. In the recent years, investors have rotated out of bonds and piled into the equities market driving up the stock prices. With most of the stocks either fully priced or overvalued, investors yearning for income have had to turn to alternate strategies. This article discusses one such strategy - using covered calls.
Covered Call Strategy
A covered call strategy allows investors holding a long position in an asset class to write call options to generate income via premiums. A quick primer: Lets say you own a stock, and intend to generate income to either supplement the stock's dividends or generate income on non-dividend paying stocks. This can be achieved by writing out-of-money (OTM) calls. If the stock price stays below the strike price at the time of expiration, you simply pocket the premium and have thus generated income in your portfolio without any other obligations. If the stock rises ends above the strike price at expiration and is called, you sell the stock at a profit, while still keeping the premium.
The Risk: Writing OTM covered call provides the writer with options income and the writer is only obligated to sell the underlying security if the stock closes above the strike price at the time of expiration. While this can be a good strategy in a sideways or bear market, this strategy does not work too well for the option writer in situations such as secular bull markets involving rapidly rising stock values, or catalysts such as analyst upgrades, surprising positive earnings or unanticipated positive business news etc.
However, consider the current environment of the market: most stocks are at an all-time high and it is slim pickings to find good valuations. The current conditions provide a perfect environment for this strategy. One pre-requirement for writing covered calls is that the writer needs to own the underlying stock. For investors who still wish to use this strategy while not owning the underlying stock, there exists a solution: Covered Call ETFs.
Surprisingly, there are more ETFs trading and available on the Toronto Stock Exchange than on the NYSEArca.
The NYSEArca market provides four main contenders, but only one ETF (NYSEARCA:PBP) provides good income compared to the other available ETFs. In fact, two of the ETFs (VEGA and HFIN) provide less than 1% yield and are barely any good for income supplementation. They have been included in the list below for the sake of completeness.
PowerShares S&P 500 BuyWrite Portfolio
Horizons S&P 500 Covered Call ETF
STAR Global Buy-Write ETF
S&P Financial Select Sector Covered Call ETF
The ETFs trading on the Toronto Stock Exchange are more focused. Most funds listed below generate income by writing covered calls focused either on a certain sector of the economy, commodity; although a couple of ETFs use a broader index such as S&P 500 or S&P/TSX60. The other advantage is that all the ETFs listed below pay monthly distributions.
Horizons Active S&P/TSX 60 Index Covered Call ETF
Horizons Enhanced Income US Equity (USD) ETF
Horizons Enhanced Income Energy ETF
Horizons Enhanced Income Financials ETF
Horizons Enhanced Income International Equity ETF
Horizons Enhanced Income Gold Producers ETF
Horizons Enhanced Income Equity ETF
Horizons Gold Yield ETF
Horizons Natural Gas Yield ETF
First Asset Can-60 Covered Call ETF
First Asset Can-Energy Covered Call ETF
First Asset Can-Financial Covered Call ETF
First Asset Can-Materials Covered Call ETF
First Asset Tech Giants Covered Call ETF (CAD Hedged)
BMO Covered Call DJIA Hedged to CAD ETF
BMO Covered Call Canadian Banks ETF
BMO US High Dividend Covered Call ETF
BMO Covered Call Utilities ETF
Covered call ETFs have some advantages to them:
- Investors hunting for income can use covered call ETFs to boost their income - this is ideal for passive income investors who rely on either dividends or income raised via premiums from writing options. This strategy is good as an alternative investment for investors on the hunt for that extra yield.
- Mitigated risk - Covered call ETFs generally speaking, due to the nature of ETFs, are diversified. Investors can generate income by gaining exposure to the stocks included in one sector of the economy or focused on a particular index.
- Low fees - Covered call ETFs have low fees compared to other active strategies. The cost of writing calls adds up limiting the profit potential, but with a small fee of 0.65-0.85% investors can gain exposure and generate income for low fees.
- Saves time - Investors do not have to repeatedly write options month after month and simply use an ETF instead.
- Complexity - The investor is saved from the complex factors that have to be considered in determining which stocks in one's portfolio are expected not to jump before the option expires, determining how much the investor is willing to risk for each security etc. The complex problems that involves analysis of all the greeks for the options, pricing etc. can be avoided by using the above-mentioned ETFs.
- The covered call ETFs will underperform in fast upward trending market.
- The active trading involved in options trading makes these ETFs a bit more expensive than plan-vanilla ETFs.
- This is not truly passive investing - Being an active management strategy, performance of the ETFs will depend on how good a trader the ETF manager or the algorithm behind the product is.
- If using the ETFs listed on the Toronto Stock Exchange, the back-and-forth conversion between USD and CAD can be a drag on returns.
The products mentioned above can supplement income for investors hungry for yield. Generation of income by writing options can be an expensive undertaking, but with the use of ETFs, costs can be kept under control. The strategy works well in flat or declining markets, but in secular bull markets where stock prices rise rapidly, the products mentioned above can underperform.
Full Disclosure: None. My full list of holdings is available here.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.