XLU: Turning A Utility ETF Into An Income Engine

Summary

• Income investors often favor utilities.
• Selling covered calls against XLU can provide total income of 7% or more.
• The option-implied price return outlook is neutral, making covered calls more attractive.
• It is important to carefully choose the strike price at which to sell covered calls.

Utilities are a common holding for income investors. Valuations for utilities are high enough today that the yield on fresh purchases looks less attractive. One alternative for income investors is to sell covered calls or cash-secured puts to generate additional income. In some recent analysis, I have been impressed by how much income was available from selling covered calls on individual utility stocks. Selling covered calls on Southern Company (SO), for example, recently provided more than 9% in annual income (dividend + call premium).

I have also found a covered call strategy on NextEra (NEE) to look compelling. Because of the diversification benefit of owning a fund, some investors may prefer option-based income strategies using an ETF. In this article, I examine the risk, return, and income potential of covered calls and cash secured puts with the Utilities Select Sector SPDR ETF (NYSEARCA:XLU, expense ratio 0.12%, dividend yield 3.3%).

One-year price chart and basic stats for XLU (Source: Seeking Alpha)

Once you start to consider covered calls, income investing gets more interesting. It is important to balance risk, potential for price appreciation, option premium income, and the probability that the option will be exercised and the shares will be called away, in which case dividend income ceases.

Price Return Outlook for XLU

I generally favor longer-dated options for income strategies. Having to roll a strategy forward as options expire takes time and I’d rather do it as infrequently as is reasonable. For this analysis, I am looking at options on XLU that expire on January 21, 2022, between ten and eleven months from now.

The market prices of options provide information about traders’ consensus outlook on the probability of the price going above a certain level (call options) or below a certain level (put options) over some period of time (from today until the expiration date of the options). By aggregating market prices of call and put options with the same expiration date but different payouts (different strike prices), it is possible to employ a mathematical model to calculate the implied probability of all possible future returns.

This strategy is well-established in institutional finance. For some background, see the Minneapolis Fed’s web pages on their implementation. For a review of the literature on how options prices are useful in generating outlooks in general and with examples using my version of this approach, see this presentation.

The option-implied probabilities of expected price returns are charted as a probability distribution. When I chart the option-implied probability distribution for future return, I rotate the negative side of the distribution about the vertical axis so that the relative probabilities of positive and negative returns are easier to see.

The price outlooks derived from options prices are probabilistic rather than a specific forecast of the future price. The options prices may indicate increased or decreased likelihood of gains or losses and this provides insight into the prevailing beliefs of those buying and selling options.

Option-implied price return distribution for XLU to January 21, 2022

The option-implied price return outlook for XLU is neutral, albeit with a very slight tilt towards small positive returns between now and January 21, 2022. The single most-probable price return from the option-implied distribution is +1.9% (the highest probability return on the chart above). For price returns from -20% to + 20% (from 0% to 20% on chart) the probabilities of positive and negative returns of the same magnitude are very similar, which equates to the options market having a neutral view.

For larger-magnitude price returns, the probability of negative returns is slightly higher than for the same-magnitude positive returns. This is common with dividend-paying stocks because the upside potential has been reduced because some portion of earnings are returned to shareholders.

One of the most important results from this type of option analysis is an estimation of loss potential. The estimated 10th percentile price return between now and January 21, 2022 is -27% and the estimated 20th percentile is -17%. This means that there is a 10% chance of a price return of -27% or worse and a 20% chance of a price return of -17% or worse between now and January 21, 2022. The annualized implied volatility from this distribution is 20%.

The neutral outlook from the option-implied price returns can inform decision-making on whether or not to sell covered calls (or cash-secured puts). If the option-implied outlook is bullish, one may prefer to retain some potential for price appreciation by selling calls with higher strike prices, for example. If the outlook is bearish, selling call options with strike prices very close to the current price of a share is more attractive. In this case, the option-implied outlook suggests a small tilt in probability towards price returns of perhaps 2%, not really enough to be a major factor.

Income vs. Upside Potential

When considering selling covered calls, there is a tradeoff between the income provided by the option premium and the potential price appreciation of the net position. The chart below is my favored approach to visualizing the tradeoff. The current price of XLU is $59.63. If you sell a January 21, 2022, covered call (you buy the stock and sell the call) with the option strike equal to $60, you are selling all but 0.6% of the potential price appreciation between now and January 21, 2022, but you are getting $3.40 in option premium (the current bid price for the call option), which equates to 5.7% in income ($3.40/$59.63). As the strike price increases, you retain more potential price return if the price of XLU increases but you get less option premium income.

Option income yield and potential price appreciation vs. option strike price for XLU (January 21, 2022 option expiration date)

Case 1

Let’s consider the case in which we sell a covered call against XLU with a strike of $65 (at the January 21, 2022, expiration date). The option premium of $1.57 equates to a 2.6% option income yield over 10.7 months. With the 3.3% dividend yield, this provides a total income of 6% over twelve months. Selling the $65 strike covered call also provides you with the potential for as much as 9% in price appreciation (if the price rises from its current level of $59.63 to $65 (or higher).

The option-implied price return distribution indicates that the probability of the price gaining 9% or less is 74%, so the most probable outcome is that selling the $65 covered call will result in the call not being executed, so you end up keeping the share of XLU (and receiving the dividend) and the option premium.

If the price of XLU goes above $65 you will sell the share of XLU for $65 (because it makes sense of the option buyer to exercise the call option) and, in this situation, you pocket the 2.6% option income yield and you have realized 9% in price appreciation. In addition to this, you have received some amount of dividends since you bought the share of XLU.

If the price of XLU never goes above $65, you have a total income of 6%, assuming the dividends aren’t cut.

Case 2

Now consider the case in which you sell the call option with a $62 strike (and expiring on January 21, 2022). This case provides 4% in potential price appreciation and 4.2% in option income yield. The total income is 7.5% (including the 3.3% dividend yield) over the next twelve months. With the lower strike price, there is a higher probability that the price of XLU will go above $62 and the option will be exercised, in which case the dividend income is curtailed. The option-implied price return distribution estimates a 64% chance that the price will not exceed $63, however.

Summary

Selling covered calls against XLU provides an additional income while also providing the risk reduction due to diversification of the ETF. In the current low-yield environment, this strategy looks appealing. The additional complexity to selling covered calls against securities with high dividend yield is that the dividend portion of the income will cease if the call is executed (i.e. if the price of the security goes above the strike price). This is of little or no concern in selling covered calls against low- or no-dividend securities (such as QQQ).

Selling covered calls against XLU looks most attractive if you select a strike price for the call that provides a fairly high probability that the option is not exercised, so that you get to keep the shares and, thereby, receive the dividends as well as the option premium.

For XLU, selling the $62 or $65 call expiring on January 21, 2022, looks like a reasonable choice. These two strike prices provide option income yield of 4.2% and 2.6%, respectively. Combined with the dividend yield of 3.3%, the total income of 6% to 7.5% looks quite attractive, especially given that utilities are somewhat expensive and would be expected to decline if interest rates rise.

Analyst’s Disclosure: I/we 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.