Writing Covered Calls With ETFs

January 25, 2017

The Bionic Advisor[This article appears in our February 2017 issue of ETF Report.]

 

Kevin Simpson

Founder & Chief Investment Officer

Capital Wealth Planning

 

Based in Naples, Florida, Capital Wealth Planning is a third-party investment manager serving financial advisors that work with the institutional market. Since its founding in 2005, CWP has specialized in the use of covered calls, particularly on ETFs.

Recently, we sat down with founder and CIO Kevin Simpson to learn more about his firm’s signature offering, the ETF Hedged Covered Call portfolio.

Why does Capital Wealth use covered calls, as opposed to other hedging strategies? 
Our focus is using options to hedge portfolios and generate ancillary income. Covered calls have a small hedge, and offer some premium. That income byproduct has been uniquely appealing over the past five years, because of low interest rates.

I’m not trying to oversell it; the income isn’t massive. But in a market where yields are low and income has been hard to find, option income has really been helpful.

Why do it with ETFs, though?
In a previous life, we did a lot of no-load mutual fund modeling, and we do a ton of work with options called “put hedging.” But what we thought was cool about ETFs is that you have the ability to do an asset allocation similar to what you can do with open-end funds, but with advantages you [at ETF Report] have written about often: being able to trade intraday, tax efficiency, what have you. For us, it was the ability to write covered calls on the actual ETF that was the most exciting part.

So how do you decide which ETFs to include?
When we designed the strategy, we wanted risk control as a primary factor. We wanted to see if we could build something with a risk profile of about half the risk of the S&P 500. That’s the driving force into how we allocate positions.

So at any given time, we have somewhere between six to nine different ETFs in there, though we’ve had as many as 11. And all the ETFs have an option chain that allows us to write covered calls.

What’s interesting about our strategy is that it’s somewhat reactionary. We’re doing the same thing month after month whether the markets go up, down or sideways. When markets are down, that prompts us to add a little risk to the strategy to bring it back up to level. And when markets are doing well, that prompts us to take risk off the table.

By that logic, it means we’ll never outperform markets to the upside. But we should be able to produce less downside exposure when markets are struggling.

Tell us about some of the ETFs you use.
For us, the SPDR S&P 500 ETF (SPY) has always been a natural core holding. The SPDR S&P Midcap 400 ETF (MDY) and the iShares Russell 2000 ETF (IWM) are two others we’ve owned to get exposure to mid- and small-caps.

We also introduced the ProShares Short S&P 500 ETF (SH), a nonleveraged inverse ETF to help hedge the downside even more when necessary. It’s a position that we almost always have a holding in, ranging from as little as 2-3% to as much as 15%, depending on where the markets are, and how much of a hedge we need to put on.

As you point out, SH is unleveraged. Do you ever use leveraged funds?
No. We don’t want to own ETFs that are 2x or 3x, which isn’t to say they don’t have a place in a portfolio, but because we’re using options on top of ETFs, the way leveraged funds price isn’t necessarily efficient for our process.

If there’s a place for leverage, I think it’s more in the shorter term. But we’re not short-term traders. People who invest in us tend to want things that are more boring [or] conservative. We’re slow and steady, like the tortoise versus the hare.

How much does cost factor into your allocation decisions?
Cost of the underlying ETFs has less to do with our strategy than for other ETF strategists, because in many cases, I’m looking for something that has an option chain versus something without. But it’s a consideration, certainly.

How do you feel about ETFs that package a covered-call strategy, like the PowerShares S&P 500 BuyWrite Portfolio (PBP)? Have you ever used those?
No; but we’re huge supporters and proponents of them. Much like the low-beta ETFs, we wouldn’t necessarily want to use a covered-call ETF, because we’re already writing covered calls as a function of the portfolio. There’s a redundancy factor, if we included them. So they probably wouldn’t be candidates for us. But we’re rooting for them, for sure.

How do you go about evaluating liquidity?
What’s more important [than liquidity in the options] is the liquidity of the ETF itself. It’s certainly important that there’s liquidity and good open interest in the option chain, because we wouldn’t want to write calls on an ETF that didn’t have a robust option chain—not for this portfolio. Ultimately, though, we want to find ETFs where we can have good option chains and tight spreads, good open interest, good volume and so on.

Are there particular asset classes or sectors you exclude?
We’re selective in terms of what ETFs we won’t own. We don’t want things that are leveraged, as we talked about. We also try to stay away from ETFs with contango or that have some kind of derivative component to them. We want funds to be as transparent and simple as possible. Again, that’s not a criticism of other products; it’s just that, with our model, we want to keep it simple.

Looking ahead to 2017, what are your expectations for the market, and how has that affected your overall strategy, if at all?
Since the financial crisis, quantitative easing has kept rates artificially low. We’ve also seen volatility staying historically low—I’m not suggesting that’s a direct result of quantitative easing and lower rates, but it certainly has an effect on volatility. A rising stock market with very low volatility—that’s affected the premium we generate on covered-call writing. With our ETFs, specifically our index-based ETFs, it’s been harder to write option premiums or find option premiums that have sustenance.

But we’ve seen volatility beginning to increase a little at the end of 2016. We’d expect that, as interest rates normalize over time, volatility could also normalize over time, and it should benefit our covered-call premiums, because higher volatility means higher income.

It’s not really a question of us doing anything different; we do the same thing every month, whether volatility is high or low. But certainly higher volatility will allow us to generate greater premiums in our covered calls. So we wait with anticipation for volatility. We like when there’s volatility in the market.

 

 

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