Options are a great way for investors to capitalize on a stock’s movement without having to shell out the money to buy it. Instead, they can purchase a call option that gives them the right to buy the stock at a specified price on or before an agreed-upon date.
Investors can also purchase put options that give them the right to sell a stock at a certain price and time, which can be helpful when trying to limit downside risk.
In this article, we will look at three exchange-traded funds (ETFs) that employ an options strategy known as a “covered call” or “buy-write” strategy to generate an income.
What Are Covered Calls?
A “covered call” or “buy-write” is an income-producing strategy whereby an investor sells, or “writes,” a call option against shares of stock that they already own. For example, an investor that owns 100 shares of Microsoft Corp. (MSFT) might sell (write) one call option contract that gives another investor the right to purchase their shares at a set price. In exchange, the seller receives fees known as “option premiums” from the other investor.
If the stock doesn’t reach the call option’s “strike price,” the call option expires worthless and the investor keeps the option premiums. If the stock surpasses the “strike price,” the other party will exercise the call option and purchase the shares from the investor. The obligation to provide the shares is covered by the long stock, but the investor could lose out on the “opportunity cost” – or the difference between the strike price and market price.
Top Covered Call ETFs
Covered call ETFs use a covered call strategy to generate an income from the option premiums over time. For example, an S&P 500 covered call ETF might purchase a portfolio that mimics the S&P 500 and then sell call options every month and collect the premiums. The fund would take these premiums and provide it as a dividend to its shareholders, which may be attractive during low interest rate environments.
The three most popular covered call ETFs include:
|Ticker Symbol||Name||Issuer||Dividend Yield||Expense Ratio|
|(PBP )||PowerShares S&P 500 BuyWrite Portfolio ETF||Invesco PowerShares||1.60%||0.75%|
|(HSPX )||Horizons S&P 500 Covered Call ETF||Horizons||4.09%||0.65%|
|(QYLD )||Recon Capital NASDAQ 100 Covered Call ETF||Recon Capital||9.73%||0.60%|
For a complete list of covered call ETFs, see ETFdb.com’s Buy-Write ETF list.
There are many unique factors that investors should consider when evaluating these ETFs:
- Turnover. Covered call ETFs tend to have higher turnover than index funds since they may be required to sell stock or options. For example, the PowerShares S&P 500 BuyWrite Portfolio (PBP ) has 43% turnover, according to its prospectus, compared to just 4% turnover for the S&P 500 SPDR ETF (SPY ).
- Dividend yield. Investors should consider covered call ETFs’ capital gains and dividend yields when evaluating them. Often times, total returns will be lower than index funds since there’s an opportunity cost involved in writing covered calls, but dividend yields may make up for this difference in total returns.
- Expense ratios. Covered call strategies involve more legwork than passive indexing strategies, which often translates to higher expense ratios. Investors should make sure that these expense ratios are justified in terms of total returns, dividends and risk profiles by looking at Sharpe ratios and other measures.
How Do They Compare?
The PowerShares S&P 500 BuyWrite Portfolio ETF (PBP ) buys an S&P 500 stock index portfolio and writes near-term S&P 500 index covered call options on the third Friday of each month. With an expense ratio of 0.75%, the ETF is the most expensive of the three funds, despite having the lowest dividend yield. The upshot is that the fund’s low volatility translates to a 3-year average Sharpe ratio of 0.86, which is higher than the other funds.
Like the PowerShares S&P 500 BuyWrite Portfolio ETF, the Horizons S&P 500 Covered Call ETF (HSPX ) invests in an S&P 500 stock index portfolio and writes near-term (1-month) covered call options. The difference is the Horizons S&P 500 Covered Call ETF sells individual call options on each stock rather than broader S&P 500 index call options. This contributes to the fund’s higher 4.09% dividend yield, although its 3-year average Sharpe ratio is a lower 0.64.
Investors can use ETFdb.com’s ETF Comparison tool to help identify the best funds for their portfolio out of these two.
The Recon Capital NASDAQ 100 Covered Call ETF (QYLD ) uses a strategy similar to the PowerShares S&P 500 BuyWrite Portfolio ETF, but uses the NASDAQ 100 as an underlying index rather than the S&P 500. With a dividend yield of 9.73%, the fund offers the highest dividend yield, while its 0.60% expense ratio is the lowest of the three funds. The fund’s one-year average Sharpe ratio is 0.50, however, making it the lowest of the three ETFs.
The Bottom Line
Covered calls are a great way for investors to generate an income without incurring significant risk. Exchange-traded funds (ETFs) provide an easy vehicle for investors to capitalize on this strategy, although they should carefully consider each fund’s strategy, total returns, dividend yield, risk profile and expenses before making a decision.
For a complete list of new ETF launches and other information, see ETFdb.com’s ETF Launch Center.