Exploring Covered Call Strategies

February 08, 2018

[This article appeared in our February issue of ETF Report.]

Income-hungry investors who seek alternatives to low-yielding Treasuries, risky junk bonds or dividend-paying stocks may want to consider covered-call options strategies.

These plays give investors potential income without reaching for yield, and a modest amount of downside protection during market corrections. Usually these strategies are done in the options market against individual stocks. However, a few exchange-traded funds are trying to make these strategies easier to enact, and offer more diversification.

There are eight covered-call equity strategies in ETF form (as well as a put-write strategy), with most of them following indexes. The general theory behind covered-call option strategies is they’re essentially “insurance” products, where an investor holds a long position in an asset and writes (or “sells”) a call option to generate income. In addition to selling the equity premium, these strategies also sell volatility premiums, lowering the portfolio’s volatility, which can improve risk-adjusted returns, market watchers say.

Covered-Call Trade-off
Advisors like these products because they provide impressive yield levels. The biggest covered-call ETF by assets under management, the PowerShares S&P 500 BuyWrite Portfolio (PBP) has a yield of 10.83%. It has $334 million in AUM and an expense ratio of 75 basis points.

The next two largest ETFs in this category by AUM also have fairly sizable yields. The WisdomTree CBOE S&P 500 PutWrite Strategy Fund (PUTW) has a yield of 3.51%, $306 million in AUM and an expense ratio of 0.38%. The Horizons Nasdaq-100 Covered Call ETF (QYLD) has a yield of 7.6%, with an AUM of $190 million and an expense ratio of 0.60%.

Those yields are much greater than SPDR S&P 500 ETF Trust’s (SPY) yield of 1.8% and the PowerShares QQQ Trust’s (QQQ) yield of 0.80%. But while investors are getting that desired income, they also give up a little in asset returns. Compared with SPY, which returned 22.4% in 2017, PBP and PUTW were up 11.4% and 10.3%, respectively. QYLD was up 18%, versus QQQ’s return of 35% last year.

If higher income is one of these ETFs’ upsides, then forfeiting some of the underlying asset’s growth is one of the downsides, say issuers and users of the products. Advisors thinking about using covered-call ETFs in their clients’ portfolios for income may need to explain why the asset return is lower, especially in a year like 2017, which produced outsized returns.

Aaron Gilman, chief investment officer of Independent Financial Partners (IFP), constructs ETF portfolio strategies for the firm’s 550 financial advisors, and says he uses QYLD when opting for a covered-call ETF. He finds they’re best used for clients who are in the distribution phase of their portfolio management and are more focused on matching a certain rate of return to compensate for their withdrawal rate.

“For someone who wants a full-juice, high-octane [portfolio construction], I would never put them in a covered-call strategy,” Gilman said. “You have to match the strategy with the underlying objective and what you’re trying to do.”



Threading The Needle
Kevin Simpson, founder and portfolio manager for Capital Wealth Planning, which runs the Amplify YieldShares CWP Dividend & Option Income ETF (DIVO), an actively managed covered-call ETF, says these strategies are geared for a more conservative investor, but one who still wants to be in equities.

“It’s still a stock, and we’re still purchasing and investing in this market,” he said. “Certainly there’s still equity risk there.”

What Gilman likes about QYLD is it diversifies the portfolio by giving investors exposure to the Nasdaq-100, but with lowered volatility and higher yield. Otherwise, he notes, advisors would be “shunning an entire sector of the market because of the yield, when it comes to the constraints and specifics of the strategies we’re building.”

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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