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If the coming months are more volatile, investors could find covered-call strategies more attractive.

Covered-call writing on a single stock position is straightforward. You own the stock and are reluctant to sell it, so you write an option. You expect the stock price to remain flat over the option’s duration. In exchange for granting the option buyer the right to buy your stock at the strike price, you’ve collected a premium.

If you’re right and the stock flatlines, you’ve pocketed the option premium and still own the stock. Wouldn’t it be wonderful if:

a) you could always be assured that you were getting a good premium,

b) the stocks you wanted to hold were never called, and

c) whenever something went against you—you should have sold the stock, because it declined in value subsequent to your decision to hold and write a call on it—the decline in the stock price didn’t exceed the option premium you received?

Stock prices don’t always move predictably, so option writers have plenty of opportunities to experience remorse. For instance: You sold a call option, but the stock rallied and got called away from you. You received the option premium, but you would have been better off had you sold the stock at its higher price, as opposed to the strike price (the price per share the option buyer must remit when she exercises her right to call away your stock).

Or, you’ve collected a premium, but the stock subsequently craters, leaving you with paper losses many times greater than the premium —and a stock without many near-term prospects.

To minimize potential remorse, consider these factors:

Overall market backdrop: Markets have resumed their year-long climb as central bankers wax dovish about the risk of future rate hikes. Against this backdrop, volatility has generally been in full retreat. Therefore, people have collected lower option premiums, and yield levels from option writing have declined. Partly as a result, investors have otherwise opted to be long in stocks and equity ETFs, to the detriment of their earlier covered-call ETFs exposure.

Volatility: The greater the volatility embedded within the option price, the higher the premium received. This varies from sector to sector and from company to company.

Underlying exposure: Covered-call writing can lessen the pain of holding an investment that gets hit hard, but only to a point. For instance, covered-call gold stocks outperformed straight long gold stocks (e.g., HEP versus XGD), but both lost money (33% instead of 30%). The 3% outperformance is scant comfort.

Juicing-up premiums: Market volatility is dampened within a broad market index. By writing options on the stocks comprising the index instead of the index itself, you can collect option premiums that are 20% to 25% higher, says Eden Rahim, portfolio manager with Horizons Investment Management. This is a meaningful advantage, further boosted by the subsequent ability to cover (i.e., repurchase) the call written dependent on its value and prospects and, when deemed desirable, rewriting on it (using a different strike and expiration date, typically).

Retaining some upside: The strategy inherently caps some upside, but investors often look to the strategy with a bullish bias. Therefore ETFs may be more appealing than individually writing on single stocks, since ETF solutions generally capture some upside, as opposed to capping it.

The conflicting objectives: Investors are often attracted by the strategy’s high-yield potential, and clients often spend the cash flows generated. But this removes the ability to take advantage of the compounding effect benefits of the strategy, and may drag down residual NAV in the underlying portfolio. While the cash flows are taxed as capital gains, NAV decay is not desirable.

What covered-call providers do

BMO ETFs: The manager aims to add 2% to 4% in yield (above the dividend yield of the underlying) to the covered-call ETFs, writing generally 2% to 5% out of the money and 1-2 months out, for about half of the portfolio. On a total returns basis, Canadian banks and utilities covered-call ETFs have held their own.

Since the firm’s covered-call utilities ETF includes U.S. utilities and telecom exposure, it’s more broadly diversified than its utilities ETF.

The covered-call Dow Jones (CAD hedged) has lagged “straight long” exposure, though still providing a significant portion of the upside of its non-covered-call counterpart, ZDJ, on a total returns basis.

Aggregate covered-call ETFs AUM for BMO is $1,269 million among 3 ETFs: Covered Call Dow Jones Industrial Average CAD hedged (ZWA); Covered Call Canadian Banks (ZWB); and Covered Call Utilities (ZWU).

Horizons ETFs: 100% covered-call written on individual underlying stock positions, one month out, generally one standard deviation out of the money. On commodities (natural gas; crude oil; silver), the ETFs are 33% covered-call-written, generally at the money.

The manager’s goal is to write at the boundary of normal and abnormal returns.

The strategy has outperformed on a total returns basis when looking at commodity-related areas, outperforming the commodities themselves. For long crude or long natural gas exposure, the ability of the strategy to capitalize on the volatility typically associated with the underlying investments, as well as the fact that it may help mitigate contango conditions (i.e., when futures prices further out the futures curve are trading at higher prices than those closer to “spot” prices) often present in crude and natural gas markets suggests the strategy could be a better way of being “long” for those seeking that exposure.

Aggregate covered-call ETFs AUM for Horizons is $420 million across 12 ETFs (and their corresponding advisor series).

First Asset: First Asset pursues a systematic 25% covered-call writing strategy across each of the stocks held in the underlying portfolio, which is equally weighted. Equal weighting has been beneficial on the technology and materials sides.

The aggregate covered-call ETFs AUM for First Asset is $37.8 million across five ETFs, covering Materials, Energy, Financials, Technology and the S&P/TSX 60.

FT Portfolios Canada ETFs: The recently introduced FT AlphaDEX Canadian Dividend Plus and US Dividend Plus (CAD-Hedged) ETFs allow for some covered-call activity to take place to supplement the dividend yield of the underlying portfolios.

Structurally, no more than 50% of the portfolio is expected to ever be written against.

Writing is at the full discretion of the portfolio manager. There currently is no options overlay strategy in effect, nor any near-term intention of implementing one, as the dividend yield currently produced by the underlying portfolio(s) is deemed sufficient at this point.

AUM for FT Portfolios Dividend Plus ETFs stood at $7.8 million as of mid-2013.

The table “Range of returns” (page 12) provides a sense of the breadth of returns experienced in the past year, as well as contrast between the returns obtained by a partial covered-call strategy and total returns from non-covered-call-written alternatives.

Conclusion

Consider a systematic/dynamic covered-call strategy. By getting the premium option and monetizing volatility by writing on individual names, you can capitalize on the effect of compounding, particularly at times of market weakness. This lets you add more to your positions in periods of price weakness. In the long term, it could be a differentiated source of alpha.

Yves Rebetez, CFA, is managing director of ETFinsight.

Source: ETFinsight Database; providers info, etc.

Originally published in Advisor's Edge Report

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