[This article originally appeared in our June 2017 issue of ETF Report.]
Exchange-listed options are versatile, flexible financial instruments that allow advisors to differentiate their services and help their clients to accomplish three important goals:
- Generate income
- Boost growth
- Protect gains
This article walks through a handful of essential strategies—nothing fancy or complex—designed to meet the three goals above.
Quantitative easing has taken the oomph out of bond yields. What can we do for a client who is depending on cash flow from an investment portfolio in retirement, for instance?
One attractive strategy is the “covered call” or “buy-write” strategy. We show how this strategy works in Figures 1a-1c.
The biggest benefit of the covered-call strategy is the positive cash inflow from the sold call. The biggest drawback is that the price of the ETF might increase above the strike price by more than the amount of premium received before the option expires; in this case, the investor has an “opportunity cost,” but no financial cost.
After selling a call on an ETF, if bullish news enters the market, the investor has the opportunity to repurchase the call, thereby offsetting the original short call, which restores the potential to profit if the ETF continues to trade higher.
- The premium received cushions the impact if the ETF’s price falls, so buy-write returns tend to be less volatile than the underlying asset’s returns. That said, a covered-call strategy is a cushion, not a hedge. The size of the protective cushion is the size of the call premium.
- Even though the maximum gain for the covered-call strategy is realized when the underlying stock trades at or above the strike price, many investors select this strategy when they have a neutral market outlook. The idea is that the call premium will generate added income while the stock prices do not breach the strike price; thus the shares held are typically not called away, and upside gains are not forgone.
- Covered-call “yields” are not the same as bond or dividend yields. When an investor sells a covered call, the amount of premium received is certain, but the investor must wait until the option’s expiration to see how much of that premium can be realized as income. If the ETF’s price at expiration is below the short-call option’s strike price, the investor realizes the entire amount of premium received.
Figure 1a. This diagram shows the risk/reward position for an investor who has bought an ETF. If the ETF moves into the green range, the investor enjoys a gain. Conversely, the investor accepts the risk of loss if the price falls into the red range. This is the initial scenario for each of the cases discussed in this article.
Figure 1b. This diagram shows the risk/reward position for an investor who has sold a call option on an ETF. A long call option offers exposure to the upside price potential of an asset; selling a call option means the investor is selling insurance to someone else, protecting the purchaser against a higher ETF price. When an investor sells a call option, they collect a premium and bear the risk that the market trades higher beyond the strike price representing opportunity cost. Yet if the ETF stays below the strike price at expiration, the investor keeps the premium (green area).
Figure 1c. This diagram shows the covered-call strategy. The investor has bought the ETF shown in Figure 1a and simultaneously sold the call shown in Figure 1b. The investor receives the premium from the sale of the call option. Even though the investor accepted the risk of the ETF increasing in price by selling the calls in Figure 1b, they hold the shares, which offsets, or “covers,” the upside price risk. The range over which the upside price risk is offset is shown in gray. The very short green rectangle below the gray area represents the call premium received up front. The potential for your ETF owner to benefit from higher valuations is restored upon the expiration of the call, or a liquidating call trade.