An excellent way for investors to generate passive income through the upside of equities and reduce risk is to use options. The vast majority of investing portfolios are made up of stocks; however, using options has become a popular investing strategy.
Options are a popular trading strategy because it allows investors to essentially “rent” their shares to other investors and collect a monthly or even weekly fee. Options may provide increased yield due to the premiums generated from covered call writing. Through a covered call, investors can collect money for giving up on potential gains from the underlying stock. The reverse is true with a put option.
What Is an Option?
Options are all about determining the probability of future price events. An option is a contract that gives the bearer the right, but not the obligation to buy or sell an asset at a certain price on or before a specific date.
Investors like options because it provides them with passive income, can be used to limit losses should the stock market fall, and can be used for speculative purposes.
There are two types of options: a call option and a put option.
What Is a Call Option?
A call option is a financial contract that allows an investor to receive money in exchange for giving up potential gains on an underlying stock. With a covered call, an investor sells someone else the option to buy an equity they currently own, at a set price, for a specific period of time.
The specified price is the strike price while the expiration date determines the option’s time to maturity. If the underlying stock climbs above the set price the buyer of the option “calls” (buys) the stock at the strike price.
In exercising the call option, the buyer used their right to buy the stock at the strike price. For that right, the buyer pays the seller a premium.
If the option doesn’t get used, the seller keeps their shares and still collects the premium for “writing” (selling) the option that was either withdrawn or wasn’t exercised.
Covered Call Strategy
A covered call strategy is “covered” because the seller already owns the underlying stock that is being sold to the buyer of the call option should it be exercised. A covered call strategy is a relatively low-risk way to limit losses. It also limits how much an investor can earn, which is why they receive income in the form of a premium.
First, investors generate income from the option whether its exercised or not. With a covered call strategy, the worst thing that can happen is the call option gets exercised and the investor has to sell the share they own. On the other hand, if the shares lose their value, the seller was still able to keep the premium. In this scenario, there is a limit to how much a seller can lose.
With other options contracts, where the seller doesn’t actually own any of the underlying shares or have cash to fulfill the option, the losses could be staggering.
A covered call strategy works best when the stock market is neutral or going sideways. This means volatility is at a minimum with the premium from the call option providing investors with an additional source of income.
Options trading is geared more for experienced investors who have a comprehensive understanding of the stock market and are comfortable getting the market direction right. It might sound easy, but if it was, there would be a lot more successful retail investors.
The fact is, timing the market is difficult for even the most experienced traders. And because options have a limited lifespan, once they expire, they are worthless. As a result, it’s imperative that anyone trading options has the time and discipline to do so.
What is a Covered Call ETF?
There is another way for investors to take advantage of options, and that’s through Covered Call ETFs. Covered Call ETFs are an easy and simple way to add a covered call strategy to an investing portfolio. Covered Call ETFs provide investors with a hands-off-approach to options trading and are typically regarded as a one ticket solution to a complex and time consuming strategy.
Through a Covered Call ETF, investors are able to benefit from the return in a basket of equities while benefiting from an increased yield due to the premium collected on the calls. They trade on major stock exchanges and have ticker symbols, meaning they can be bought and sold just like a stock.
Covered Call ETFs sell call options on a portion of the basket of securities. When an ETF sells a call option, it collects the premium from the option buyer, which it pays out as additional income. The ETF also generates income from any dividends held by the fund.
A portion of this income is returned to investors in the form of a high yield dividend. That’s one of the biggest draws of a Covered Call ETF. In fact, a report from CIBC Markets Inc. called Covered Call ETFs “the go-to product for Canadian investors who want a high yield—a feature of paramount importance for retirees who are often living off distributions.”
The typical yield on a Covered Call ETF is anywhere from 5% to 10%. This is significantly higher than the S&P 500/TSX composite’s current yield of approximately 2.82%, and higher than the current inflation rate of 5.1%.
This explains why more and more investors are turning to Covered Call ETFs and why more Covered Call ETFs are being launched. There are currently 65 Covered Call ETFs in Canada, with assets totalling around $12 billion.
Not all Covered Call ETFs are created equal. The biggest determinant of total returns (income and growth) is the underlying stocks held by the fund.
Investing in Covered Call ETFs
In Canada, there are a lot of ‘options’ to choose from when considering covered call ETF investments. In this rising-rate environment, covered calls are becoming increasingly popular, especially with yield-hungry investors.
If you’re thinking of investing in covered calls, consider these ETFs that utilize active covered call strategies in Canadian financials, materials and mining, U.S. banks, European banks and healthcare companies:
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