Exploring Covered Call Strategies

February 08, 2018

Jonathan Molchan, head of product development and portfolio manager at Horizons ETFs, which issued QYLD, says the ETF sells call options on the Cboe Nasdaq-100 BuyWrite Index, giving it about one-third less volatility than QQQ. He says because the Nasdaq volatility index has more implied volatility than the S&P 500 volatility index, writing call options on the Nasdaq means higher premiums and more income.

IFP’s Gilman says those two reasons are why he prefers QYLD over the other covered-call ETFs that follow the S&P: “It’s not worth it in my opinion [to use S&P 500 covered-call strategies] to get an extra 80 basis points or 1%, because you’re not going to get a ton of money selling calls on the S&P 500 itself.”

While covered-call ETFs may have lagged the broader indexes returns in 2017, it’s very rare that stock markets have back-to-back stellar performances. With consensus forecasts calling for tamer returns in 2018, a basic covered-call strategy may be a good idea, says Brett Manning, senior market analyst at Briefing.com.

 

 

“A strategy where you want to keep exposure to the stock market, but [expect it to be in a] consolidation stage is pretty much perfect for a covered-call strategy. Right now, the strategy seems to me to be very well-timed,” he said, advising investors to fully understand how the strategy works in an ETF wrapper.

Worst-Case Scenarios
The worst possible case for these options strategies is when the market experiences real volatility, rather than implied volatility, when prices fall sharply, only to rebound significantly the next month, says Gaurav Sinha, asset allocation strategist at WisdomTree, which issued PUTW.

“In that scenario, what will happen is you’ll participate on the downside, but on the upside, all you get is a premium,” he said.

PUTW is different than covered calls because it sells puts. Sinha says it will sell an at-the-money put option on the S&P 500 wherever the index closes on the third Friday of each month. Although the mechanism is different, the idea of insurance by selling volatility is similar. The fund has a beta of 0.65 versus the S&P 500 Index.

David Varadi, director of research and portfolio manager at Blue Sky Asset Management, uses both PBP and PUTW as a small part of its QuantX Funds, which are ETFs-of-ETFs. He says that although these aren’t going to give market-beating performances, they offer better risk-adjusted returns with low volatility.

“You know you’ll be able to earn returns in a wide variety of market environments, whether it’s bull, bear or sideways,” he explained. “So it’s meant to be sort of all-weather.”

Because covered-call strategies have lower volatility, Varadi says it’s possible to skew the traditional 60% equity/40% bond portfolio to something closer to 75% equities/25% bonds. 

Although these options strategies may leave a little money on the table in strong bull markets, they help to offset some losses in down markets. Sinha says that because of the premiums collected, the investor’s portfolio drawdown during bear markets is less. For example, if the premium collected is $5, and the contract fell by $100, the net loss is $95.

“In a sense, what’s happening is that, on the downside, the fund’s giving you sort of a shock absorber,” he said. “If the market goes down, probably [implied] volatility is going up, and if volatility goes up, the premiums you’re collecting are also going up.”

 

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