Using ETF Covered Calls To Soften Sell-off

April 15, 2014

Covered-call options can make volatile markets less scary, according to one RIA.

The S&P 500 Index has been retreating in recent weeks, thanks to a sell-off in momentum stocks, as investors continue to digest escalating tensions between Russia and Ukraine escalate, coupled with weak economic data out of China.

But covered-call strategies using ETFs can be a great way to offset losses and even stay in the black, according to Kevin Simpson, president and chief investment officer of Naples, Fla.-based Capital Wealth Planning.

Simpson told ETF.com that his firm was able to keep many portfolios in the black in the first quarter using its own custom-made covered-call strategies. But he also said that even covered-call strategies packaged in stand-alone ETF wrappers are a relatively safe way to buffer returns in volatile markets.

ETF.com: So how did your portfolio fare during the last quarter?

Kevin Simpson: Our covered-call ETF portfolio posted a positive return in the first quarter. Typically, our covered-call overlay benefits from sector sell-offs that have a tendency to pull down the broad market. For Q1, the momentum that came out of specific tech names and small- and midcap biotech names likely helped our covered-call overlay.

Our overlays generally benefit from broad market sell-offs a bit more than single-sector sell-offs, but we certainly benefit from pullbacks and volatility more so than we do a straight-up market, like the one we saw in 2013. And we expect to be able to sell a few more covered calls more effectively than we were able to last year, if volatility continues to enter the market.

ETF.com: Can you give us a breakdown of your portfolio?

Simpson: We have a 10 percent allocation to the ProShares Short S&P 500 ETF (SH). We have some sector exposure in consumer staples [the Consumer Staples Select Sector SPDR Fund (XLP | A-91)], health care [the Health Care Select Sector SPDR Fund (XLV | A-92)], and we just made a small allocation to gold [the SPDR Gold Trust (GLD | A-100)], which we haven’t owned in the portfolio since 2011.

ETF.com: When did your firm begin to roll out the covered-call strategy, and why?

Simpson: Capital Wealth Planning was started in 2005, and we really started building ETF portfolios around the end of 2007. We have $400 million under management.

The covered-call strategy is interesting in that it is an ETF-based product. We only purchase exchange-traded funds.

We sell out-of-the-money covered calls—[when the strike price is above the current trading price of the underlying security]—from the exchange-traded funds that we own in the portfolio.

When ProShares came out with its inverse exchange-traded funds, it allowed us to implement the downside protection we needed. But it wasn’t until around 2007 where there was enough liquidity around that ETF [SH] where we could sell covered calls on the inverse position.

 

ETF.com: 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.

ETF.com: 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.

ETF.com: 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.

ETF.com: 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.

 

Find your next ETF

Reset All