Using ETF Covered Calls To Soften Sell-off

April 15, 2014 How do you explain a covered-call strategy to investors?


Simpson: We look at covered calls as a way to produce a modest income stream but, more importantly, we look at covered calls as a way to reduce volatility. When volatility is very low, as it’s been for some time, the premiums that we generate will be on the lower end of the spectrum, but you’re capturing market appreciation.

Conversely, when volatility is very high, as it was late 2008, option premiums are more robust. For any covered-call strategy, options are priced based on volatility. Quite simply, the option premiums that we brought in—in late 2008 and early 2009—were far, far greater as a percentage to performance than they were in 2013, when volatility was at a very, very low end of the spectrum. What are your views on existing and new covered-call ETFs such as the Recon Capital Nasdaq 100 Covered Call ETF (QYLD)?

Simpson: I am excited about the “mainstreaming” of covered-call strategies. But there will be times when more active overlay techniques like what we do may be more appropriate for certain accounts.

Markets move so quickly these days that one could make a case for tactical-option strategies versus a “more mechanical” style. But from our perspective, risk-adjusted performance benefits from the consistent use of any systematic covered-call strategy.

Understandably, people abandon the technique quickly in a rising market. Over time, however, covered-call writing reduces risk and has the ability to offer competitive returns. What do you mean by “mechanical style”?

Simpson: Mechanical strategies are static and are not set to take advantage of weekly or sequential moves in the market. The average investor may not be aware that the market jumps around 60-70 basis points every day, which provides opportunities to close out positions ahead of schedule.

On April 10, we saw a 2 percent downward move on the S&P 500, so for example, with our covered-call option strategies, a negative 2 percent move in one day may allow us to close a position for a substantial premium-capture prior to expiration. What’s the biggest misperception you’ve heard about covered-call strategies?

Simpson: I think the biggest misconception of covered calls is that they’re an exotic and risky derivative. Certainly, covered calls aren’t for everyone, because there are tax implications involved with stocks that could get called away.

But the idea of covered calls being an element in a portfolio that may produce some income—but more importantly can reduce a degree of risk in volatility—I think is very, very important.

So we feel we have a strategy that’s appropriate for the conservative investor and institution that’s looking to participate when markets increase. But at the same time, those investors are also concerned about protection to the downside and, to a certain extent, are looking for an alternative income source.


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