When it comes to income-oriented offerings, the Canadian ETF industry excels. Specifically, ETFs employing derivative income strategies have become immensely popular in recent years, with a slew of firms offering extensive lineups of these funds.
In a prior two-part series on these so-called “covered call ETFs”, I went over some of the most notable firms and their range of offerings. However, if you're a new investor, getting a thorough understanding of how covered call ETFs work is probably a good idea before you consider buying one.
Here's the one-stop-shop guide on covered call ETFs, covering (no pun intended) everything you need to know as a Canadian investor.
What is a covered call strategy?
A covered call (also known as a "short call" or "buy-write") strategy involves owning 100 shares of an asset (like a stock or ETF) and simultaneously selling a call option on that stock.
A call option gives the buyer the right, but not the obligation, to buy 100 shares of a given stock at a specified price (the "strike price") before a certain date (the "expiry date").
In general, investors sell covered calls to generate income. The covered strategy allows the investor to earn a premium from selling the call option, which can also offset some losses. However, the strategy caps the upside potential; if the stock surges in price, the investor can't participate in gains beyond the option's strike price.
A hypothetical example
Suppose you own 100 shares of ABC, which is currently trading at $50 per share. You're neutral to slightly bullish on the stock's prospects, so you decide to implement a covered call strategy. You sell one covered call with a strike price of $55, expiring in one month, for a premium of $2 per share.
- The stock price remains stagnant or drops: In this scenario, the call option you sold expires out-of-the-money and is worthless. You keep the premium you received from selling the call option ($2/share * 100 shares = $200), which somewhat offsets any losses from holding the stock.
- The stock price rises but stays below $55: Like the first scenario, the call option expires worthless, and you keep the premium. In addition, you also benefit from the stock's share price increasing.
- The stock price exceeds $55: In this case, the call option will likely be exercised. You will have to sell your 100 shares of ABC at the strike price of $55 per share, even if the market price is higher. However, you still keep the premium and benefit from the stock’s appreciation from $50 to $55. Your profit, however, is capped at the strike price, and you don't participate in any further gains beyond that.
Benefits and risks of covered calls
A covered call strategy allows you to generate some income from a stagnant or slightly bullish stock. It tends to outperform in range-bound, sideways-trading markets.
However, this strategy caps your upside potential if the stock surges beyond the strike price. In prolonged bull markets, a covered call strategy can significantly underperform a regular long-only buy-and-hold strategy, especially after transaction costs.
Moreover, while the premium generated can offset some losses, it doesn’t provide a true hedge against downside risk. If the underlying shares perform poorly, investors are exposed to their full losses, offset to a degree by the option premium amount.
Keep in mind that the income generated by a covered call strategy can also fluctuate based on a variety of factors such as expiration date, the moneyness of the option, and implied volatility. In general, premiums are maximized when expiry dates are further out, the asset’s market price is close to or under the strike price, and the underlying stock’s implied volatility is high.
What is a covered call ETF?
A covered call ETF is simply a professionally-managed investment vehicle that implements the covered call strategy on your behalf. In this case, the ETF takes investor capital and puts it to work in an asset portfolio while implementing a covered call overlay. This asset portfolio can comprise stocks, as well as bonds or even commodities.
By doing so, the ETF usually targets a higher-than-average yield, which is usually paid monthly. It also participates in some of the upside of the underlying assets. The same risks with capped upside potential apply to these ETFs. Their distributions are usually taxable in multiple ways, which can include eligible and non-eligible dividends, capital gains, ordinary income, or return of capital.
The strategy each covered call ETF employs can differ significantly, so make sure you read the ETF's prospectus closely. In general, the covered call component in these ETFs can be managed in two ways: systematic or actively managed.
Systematic covered call ETFs follow a predefined set of rules for writing call options. These rules are typically based on certain parameters like moneyness and the options’ expiration date. For example, an ETF might consistently sell one-month, at-the-money call options on all the underlying assets in the portfolio. The idea behind this strategy is to minimize management costs and closely track the performance of a specific benchmark or index.
In contrast, actively managed covered call ETFs, involve a fund manager making individual decisions about when and how to sell call options. They may vary the strike price and expiration date based on their market outlook, the implied volatility, or the individual characteristics of the underlying assets. The goal of active management is to outperform a specific benchmark or generate a specific outcome, such as a certain level of income.
To find the best Canadian-listed covered call ETFs, investors can use the CBOE ETF Screener. As a start, here is a list of the top five Canadian covered call ETFs in terms of assets under management (AUM) as of June 1st, 2023:
- BMO Covered Call Canadian Banks ETF (TSX:ZWB) (AUM $2.8B)
- BMO Covered Call Utilities ETF (TSX:ZWU) (AUM $1.8B)
- BMO Canadian High Dividend Covered Call ETF (TSX:ZWC) (AUM $1.6B)
- BMO US High Dividend Covered Call ETF (TSX:ZWH) (AUM $972.1M)
- BMO Europe High Dividend Covered Call ETF (TSX:ZWP) (AUM $754.1M)
*AUM as of June 6, 2023.
This content was originally published by our partners at the Canadian ETF Marketplace.