Understanding the benefits of covered call ETFs
Covered call strategies are gaining attention among investors, especially when packaged within an exchange traded fund (ETF) vehicle. These strategies aim to generate additional cash flow over dividends using short call options and long equity positions, potentially enhancing the overall return and mitigating portfolio volatility of the fund.
A covered call strategy involves owning (or buying) underlying stocks and then selling (writing) call options on those same stocks, or on an index representative of the stocks in the portfolio. The premiums received from the sale of these call options aim to generate additional cash flow available to the investor, on top of the regular dividends from the underlying equities, contributing to an additional cash flow to the investor.
Let’s look deeper into how this works.
A covered call ETF actively invests in stocks, for example large-cap companies. Simultaneously, the ETF writes call options on the stocks in the portfolio, or an index representing the stocks in the portfolio e.g. the S&P 500. The premiums collected from the sale of these call options can provide additional cash flows to investors.
The design of a call writing strategy can affect the size of the premium collected and the ability for potential capital appreciation. Shorter term call options with a disciplined rebalancing schedule can generate more yield. Options with a higher strike price potentially allows for greater upside but tends to generate lower premiums compared to call options closer to or “at the money” relative to the underlying asset. The call options may be written so that the notional value equals most of the value of equity securities in the portfolio. Thus, the design of the option strategy is at the portfolio manager's discretion.
This combination offers four distinct benefits.
- The premiums received from the sale of the call options can potentially offer a steady stream of cash flow.
- Provides the potential for long-term capital appreciation from the equity investments.
- Generation of cash flow can also provide some relief during market downturns, thereby reducing overall portfolio volatility. These benefits work together to enhance the return to risk profile of the portfolio.
- Option premiums are generally taxed as capital gains or treated as return of capital which can be more tax efficient than income.
In essence, a covered call strategy within an ETF works as follows: equities (the core part of the portfolio is invested in the market) plus the short call option (written on an underlying index or stock) equals potential cash flow plus capital appreciation. Additionally, premiums collected can potentially mitigate overall portfolio volatility.
While a covered call strategy can offer an attractive cash flow solution and the potential for capital appreciation, it comes with its own set of risks. For instance, the ETF may be required to sell the underlying asset or settle in cash for an amount of equal value, should the market or stock rise beyond the strike price of the call option, essentially capping the upside potential of the underlying holdings. Also, the premiums received from writing call options may not exceed the returns that would have been achieved if the ETF had remained directly invested in the securities subject to call options.
In conclusion, a covered call strategy within an ETF can be used as a tool for investors seeking to generate additional cash flow and potentially grow their investments, all while possibly reducing portfolio volatility.
Remember, though, that every investment strategy has its own set of risks, and it is crucial to thoroughly understand them before investing. Always read the prospectus for more details on risks associated with the strategy and consult with a financial advisor to ensure the strategy aligns with your investment goals and risk tolerance.
To learn more about Fidelity’s covered call ETFs, visit fidelity.ca/CoveredCalls
