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Aggressive Dividends was wondering why covered call ETFs had "lackluster" performance, for example the PowerShares S&P 500 BuyWrite Portfolio (PBP). This is an ETF that tracks the CBOE S&P 500 BuyWrite Index, which essentially measures the value of selling calls on the S&P 500 index. Per the ETF's summary description:

This strategy consists of holding a portfolio indexed to the S&P 500® (Reference Index) and selling a succession of written options, each with an exercise price at or above the prevailing price level of the S&P 500. The CBOE S&P 500 BuyWrite Index provides a benchmark measure of the total return performance of this hypothetical strategy. Dividends paid on the component stocks underlying the S&P 500 and the dollar value of option premiums received from written options are reinvested.

So if you follow this index, what you're essentially doing is buying the S&P 500 and then selling calls that are at the money or just above the index level every month. In some months you're called. In some months you aren't.

The BuyWrite Portfolio ETF isn't really "lackluster." It's performing as designed. It's a hedged strategy and it only performs exceptionally well under certain market conditions. To demonstrate how this strategy works, I created a scenario of selling calls on the SPDR S&P 500 ETF (SPY).

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Selling calls every month: A hypothetical simulation

What's the benefit of selling a call? You collect money. The risk? That your stock will be called away at lower than its actual value at expiration (or before expiration), or that the stock will go down way more than the value of the call you sold.

So here's my hypothetical simulation. It begins in September 2010 with the purchase of 1,000 shares of SPY and selling calls just below and just above where SPY was trading in rough proportion to the strike prices (for example, with the index at 121.5, selling five 121 calls and five 122 calls). At expiration, I sold another set of calls (repurchasing SPY if my shares were called away).

Here are the results (not accounting for commissions). Each line shows a stock purchase and the outcome of that transaction when shares were finally called away. (I assumed that the February 2012 options would be in the money). The income column represents option premium and dividends collected.

Note that there were several stock purchases that were called away for a net loss. That's because if any calls expired worthless, new lower strike calls were sold. But overall, the option premium income and dividends more than made up for those losses.

Here's a look at the at the net position of this hypothetical simulation over the time period, compared to simply purchasing SPY in September 2010, reinvesting dividends and not selling calls.

The purple line does not account for premium embedded in the calls. It merely represents the actual value of the stock, or the maximum value of the position based on the short call strikes, whichever was lower at the time.

Now let's take a look at the actual CBOE Buy Write Index over the same time period

This looks pretty similar to my hypothetical simulation, which I expected of course, but the table above shows why the index behaves the way it does.

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Buy-write performance in real life. Less volatile … sometimes

Of course if you can buy the PBP ETF, there's really no need to go through the bother and expense of buying SPY and selling calls. Here's a look at how a $10,000 portfolio would have performed invested in both SPY and PBP over that same time period.

Adding PBP to your portfolio could dampen volatility. In fact, this ETF is usually less volatile than SPY itself. Here's a look at one-month historical annualized volatility for both PBP and SPY

A covered call strategy on SPY may be less volatile than SPY itself - but take note of the asymmetrical relationship. When the market tanks, PBP becomes almost as volatile as SPY.

That's because while selling calls generates income and dampens the downside, losses on SPY can outweigh the premium collected. After all, selling a call for 2% of the value of the underlying is relatively small consolation if the market drops 12%.

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Sell calls further out?

Aggressive Dividends suggested that performance could be improved by selling longer dated calls.

Fund managers should consider adding call option writing with 3, 6 and 12 month expiration dates. Blending option writing from monthly up to LEAPS would increase management fees but may provide more rounded out protection when considering volatility risk over a variety of time frames.

I doubt the protection would be all that "rounded out" for an indexed ETF. Selling an at-the-money LEAP, for example, would collect a fair amount of premium, but it would cap gains over a really long period of time and certainly would not have provided much comfort during the 2008 crash.

An individual investor might have a portfolio of differently dated short calls, which might do fine, but that would be difficult to index. An ETF with a whole bunch of longer-dated short calls in its portfolio would get really complex really quickly. And the fund's expense ratio is already 0.75%. I can't see paying more.

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Hedging the covered call hedge

There's no law that says you have to sell the same number of calls as shares you own. In fact, I think it's often a mistake. What if, for example, you sold 8 calls for every 1000 shares of SPY you owned?

You would not collect as much money, but you'd collect some. You'd get less of that so-called downside protection, of course, but more gains if the market marches higher.

If you want a hybrid approach, consider buying PBP, but perhaps buying 2 shares of SPY for every 10 shares of PBP you own - or whatever other ratio you feel comfortable with. When implied volatility is high, think about owning more PBP than SPY. When implied volatility is low, consider owning less PBP than SPY because you're probably not being adequately compensated for selling calls in that environment.

So a covered call ETF like PBP might be a good core holding if you think the market is going to trend (either up or down) within reasonable parameters or just drift. It's less volatile most of the time, but you can't expect to make as much money in markets that consistently soar higher, nor hedge steep losses if the market crashes.

If you buy PBP, note that one of the "principal risks" in the prospectus (PDF file) is "US Federal Income Tax Risk," because a good portion of the distributions you'll receive could be short-term capital gains. Consult your tax advisor, but it might be best to consider this ETF for a tax-deferred account.

Here's what I'd like to see: A buy-write portfolio that sells weekly call options on SPY. Those weekly options seem to offer a lot of premium these days. I wonder how that would work out. I'm actually thinking it would perform better. And perhaps the CBOE is already working on an index to track that.

Source: Covered Call ETF Performing As Designed, But Hedging Isn't Always Easy