A Closer Look At Buy/Write ETFs

by on March 11, 2013 | ETFs Mentioned:

The sheer growth in the number of ETFs has been staggering. What started off as a simple way to track basic stock and bond market indexes has ballooned outwards quite rapidly. Retail investors now have the ability to use ETFs to access a variety of asset classes once reserved for wealthy or institutional sized investors. From commodities to managed futures, regular Joes’ portfolios can now compete with the big boys. One such strategy now available for smaller portfolios is that of buy/write options. By placing a single trade, investors can now simply implement the tactic and there’s plenty of reason to want to [see Free Report: How To Pick The Right ETF Every Time].

Buy/Write 101Buy Write ETFs

Option overlay strategies have often been the realm of day traders, high net-worth individuals and institutions. While some can be very complex–consisting of many moving parts–the buy/write or covered call strategies are some of the simplest to understand.

At its very basic, a buy-write or covered call is an investment approach where the investor buys a stock or a basket of stocks tied to an index and writes call options that cover the stock position. A call option gives its holder the right to buy a stock from the option seller at a certain price by a certain date [see A Closer Look At Managed Futures ETPs].

For example, an investor owns 100 shares of ABC Corp. currently trading at $10. Later, the investor decides to write a call option for ABC stock at an exercise price of $12.50. The investor gets a small fee for agreeing to the contract. As long as the price of ABC stays below $12.50 until the contract expires, the investor will keep the premium. If the price rises above the $12.50 level and the option is exercised, the investor will be required to sell the shares at $12.50 to the option holder. The trader will only lose out on the difference between the exercise price and the market price. However, the investor still has made a nice $2.50 per gain plus the option writing fee.

By writing the call, an investor caps the upside potential of the underlying stock, and generates income from the fee the option buyer pays. Aside from this income potential, the advantages of writing covered calls are that the option premium cushions downside moves in an equity portfolio. Investors can lose money if the stock or index drops by more than the amount of the premium received. However, the premium acts like a buffer in case of significant market dips [see How To Swing Trade ETFs].

Normally, writing covered calls can be an expensive proposition – writing options on a company like Apple (AAPL) will set you back about $45,000. By taking a sophisticated tool and placing it in a neat exchange-traded package, more retail investors have the opportunity to use it in their portfolios. These ETFs eliminate the lengthy research, expense and “manual” call writing.

PowerShares S&P 500 Buy-Write (PBP, B+)

For investors, the PowerShares S&P 500 Buy-Write (PBP) is the grandfather of the ETF options for the strategy, and it was launched back in 2007. With $245 million in assets under management, it’s also the largest. Expenses for PBP run 0.75%.

The fund is based on the CBOE S&P 500 BuyWrite Index, which is considered the gold standard in the covered call world. The ETF will invest at least 90% of its total assets in securities that comprise the index, including at least 80% of its total assets in common stocks of the 500 companies included in the S&P 500 Index and will write (sell) call options thereon. The index measures the total rate of return of an S&P 500 covered call strategy [see Cheapskate Hedge Fund ETFdb Portfolio].

AdvisorShares STAR Global Buy-Write ETF (VEGA, B-)

The AdvisorShares STAR Global Buy-Write ETF (VEGA) is the newest buy-write fund to hit the marketplace; it was launched back in September of 2012. The fund is actively managed and doesn’t follow a specific benchmark. VEGA is sub-advised by Partnervest Advisory Services and seeks to achieve returns by using a proprietary strategy known as Volatility Enhanced Global Appreciation (“VEGA”). Partnervest then employs a buy-write overlay for its global allocation strategy using various other ETFs.

So far, the active strategy hasn’t quite caught on with investors. VEGA features just $16 million in assets and trades only about 6000 shares a day. That could be due to the fund’s significant underperformance of its comparative benchmark or its high 2.01% expense ratio.

Either way, investors seem to want name brand index exposure when it comes to their buy-write holdings [see ETF Technical Trading FAQ].

iPath CBOE S&P 500 Buy-Write Index ETN (BWV, C)

For those investors who prefer to get their covered call exposure via an exchange traded note, iPath’s CBOE S&P 500 Buy-Write Index ETN (BWV) offers very similar exposure to the PowerShares fund. Like PBP, the iPath ETN tracks the CBOE Buy-Write Index, which is designed to measure the total rate of return of a hypothetical “buy-write” or “covered call” strategy on the S&P 500.

Also, like PBP, there have been times when the fund has outperformed the S&P 500–during the market crash in 2009 for example– as well as underperformed it. However, its real underperformance seems to have come from investors [see How Well Do The 5 Biggest ETFs Track Their Indexes?].

BWV barley trades at all, while it has only amassed $11 million in assets. Much of this can be attributed to the fact that unlike PBP, the iPath ETN does not pay a dividend. Much of the appeal of using a covered call strategy is getting that option premium paid back to you. BWV rolls that “dividend” back into the fund as part of its total return mandate.

Expenses run an identical 0.75% to PBP.

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Disclosure: No positions at time of writing.