Volatile markets are not traditionally a place where income-generating assets thrive, however there is a way to potentially capitalise on sideways or choppy market conditions – covered call strategies. 

Although they are usually a tool for sophisticated investment professionals, covered call strategies (also called ‘buy-writes’) have become more accessible via Exchange Traded Funds (ETFs) on ASX. 

In suitable markets, covered call strategies have the potential to deliver competitive returns, in Global X’s opinion.

To ensure covered call ETFs are the right solution for an individual’s portfolio, it is important to understand how they perform in different markets – and their risks.

[Editor’s note: Do not read this article as a recommendation to invest in ETFs that use covered call strategies. These strategies typically have higher risk and suit more experienced investors and traders. A sudden change in market conditions can affect the performance of covered call strategies. Do further research of your own or talk to you adviser about whether using an ETF to implement covered call strategies suits your investment needs.]

Why do covered call strategies suit volatile markets?

Economic policy has created a bumpy ride for investors across the globe as central banks attempt to alleviate inflation pressures caused by COVID-19. The flow-on effects of this have been broad, with the recent casualty of Silicon Valley Bank being a timely reminder of just how volatile markets can be. 

Investors looking for returns can consider covered call strategies, which might potentially produce higher yields during periods of market volatility. 

Covered calls generate yield from the premiums which are earned from placing an options contract on where an underlying index which tracks a market will be sitting after a specified period of time. 

The more uncertain market conditions are, the more difficult it is to predict how an index will perform, therefore a higher premium – and in turn, yield – can be earned. 

Volatility, which essentially captures the uncertainty around the direction of share prices, usually spikes when markets are suffering to the downside – such as in the wake of significant market events like the Global Financial Crisis and the initial Covid-19 crash in 2020. 

Tellingly, as equities fall, many investors’ portfolios are likely to take a hit. This is where, due to the premiums received from selling calls, covered calls strategies may be able to offer some downside protection in bear markets (see the chart below for an example using the NASDAQ-100 Index). QYLD in the chart below stands for the Global X NASDAQ 100 Covered Call ETF (ASX: QYLD).

It is important to note that these strategies are still exposed to market downturns. However, the premiums might partly offer a buffer in those scenarios, in Global X’s opinion.

What Happens to Covered Calls in Sideways or Positive Markets? 

If the underlying index which a covered call ETF is tracking stays flat, it is expected to outperform because the premiums being earned will likely be above what the market returns. 

However, when a market is trending up, covered call strategies won’t keep up as the upside is capped at the level of the premium received (from selling the call over the index) – essentially there is a ceiling on the amount of upside market movement a covered call ETF can capture. 

Hence, it is important to understand which market conditions will garner the best results from covered call strategies as well as the level of risk a portfolio can take on in the pursuit of income generation. 

Moreover, the time horizon of an options contract influences the yield potential from covered call strategies. More often than not, options contracts generate higher premiums for longer maturities. This is because the further in advance a call is made on where the market will be, the more uncertain market conditions could be over its longer time period. 

For this reason, covered call ETFs usually place monthly or quarterly options contracts – aiming to balance market risks and yield potential.

Should an Investor Consider Covered Call ETFs or Single Stocks? 

All this being said, why would an investor choose to use a covered call ETF rather than making options calls on individual stocks? It comes down to the cost and complexity of doing so. 

Making a covered call on a single stock requires a higher degree of trading activity and sophistication. The other issue is that not all stocks in an index have a liquid options market. Therefore, to recreate a portfolio of covered calls which replicate an underlying index would be virtually impossible. 

Separately, making options calls on single stocks often comes with a hefty price tag due to trading costs.

In Global X's view, covered call ETFs can potentially mitigate these concerns. They are managed by investment professionals which can remove the need for in-depth technical understanding of the options markets; they can reduce individual stock risk by tracking an entire underlying index (which would otherwise be virtually impossible to capture); and costs are in many cases more transparent and predictable by reviewing an ETF provider’s management fees. 

Covered Calls are Not as Complicated as They Appear

When it comes to generating income, an investor shouldn’t judge a covered call by its cover. What may appear to be a daunting strategy, can be used effectively in the right market for the right investor. 

With the introduction of covered call ETFs, Australian investors can access a new tool to potentially help enhance and diversify portfolio income. 

DISCLAIMERS

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