Making the Covered Call For Unique Income

The “holy grail” of generating income is doing so with reduced risk, be it lower interest rate risk or mitigated equity risk. Accomplishing that objective is easier said than done, but it is possible and it’s not a stretch for advisors to get there.

The options market, specifically buy-write strategies, stands as prime opportunity for generating robust levels of alternative income while damping the aforementioned risks. Covered calls, including in fund form, are solid avenues for generating income outside the realms of stocks and bonds. This strategy is increasingly accessible via exchange traded funds, many of which sport big yields and tolerable expense ratios. Plus, the asset class is pertinent in the current environment.

Chances are advisors and clients alike are increasingly familiar with covered call funds, particularly in the exchange traded funds wrapper. Data confirm as much. As of July 31, such ETFs had taken in $17.4 billion in fresh assets on a year-to-date basis – an impressive haul considering this is an ETF genre that usually doesn’t command a lot of headlines.

Covered call strategies are often rewarding in turbulent market settings because options premium move higher, meaning more income to options writers or sellers.

Parsing Through Various Covered Call Strategies

Indeed, covered call ETFs typically sport impressive levels of income, but before rushing in, clients should be aware of important differences between these products. After all, similar fund titles can be misleading to unwitting market participants. That’s where advisors come in.

“We believe another important consideration is how different ETFs manage their call-writing strategies. Some funds seek to maximize distributions by selling (i.e. writing) calls against a high proportion of their underlying equity holdings,” according to First Trust research. “Such strategies effectively forgo potential appreciation of those holdings in exchange for the income generated from call premiums. Other call-writing ETFs may sell calls against a smaller proportion of their underlying holdings, forgoing some level of call premiums in favor of more potential upside participation. Hence, the overwrite percentages and distribution levels of call-writing ETFs are key data points, in our opinion.”

For what it’s worth, Illinois-based First Trust is the issuer behind multiple buy-write ETFs, several of which can be accurately described as “successful.” So while the fund sponsor has skin in the game, its opinions on this asset class are relevant. It adds that how buy-write ETFs lob off distributions is also important to clients.

“Another aspect of an ETF’s call-writing strategy that may be useful to evaluate is whether its distribution objective is relatively constant or variable,” adds First Trust. “Options premiums tend to rise and fall with equity market volatility, so a strategy that seeks to maintain a relatively constant overwrite percentage may produce larger distributions as volatility increases and smaller distributions as volatility decreases. On the other hand, a strategy seeking to distribute a more stable level of income may be able to achieve this objective by selling fewer calls (i.e. with more upside potential) as volatility increases and more calls (i.e. with less upside potential) as volatility decreases.”

The point: Covered call strategies are considered alternative investments, meaning they can bring diversification and reduced correlations to portfolios. More importantly, they’re highly relevant in today’s turbulent fixed income climate.

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