Exchange traded funds continue to increase in number and popularity, growing to one of the most commonly traded securities on the stock exchange as both institutional and the average retail investor gain greater access to broad or specialized market exposure. Yet many individuals are unfamiliar with ETFs’ inner workings. In this ongoing series, we hope to address your questions and help shed light on the investment vehicle. [What is an ETF? — Part 25: Commodity ETFs & Taxes]

In the ongoing search for yield, some investors have discovered buy-write ETFs and their attractive payouts over 10% in some cases. Still, like most investments, it is better to have a handle on the inner workings of the fund before actually diving in.

The buy-write, or covered call, strategy utilizes call options on a position to generate high income from option premiums. An investor would sell a call option above the current price of a security. If the price of the security is below the option upon the expiry date, the investor would pocket the difference.

Buy-write traders would only lose out on the difference of the exercise price and the market price. During market turns, traders can lose money if the security drops by more than the amount of the premium received – the premium acts like a buffer in case of significant market dips.

Buy-write strategies “provide option premium income that can help cushion downside moves in an equity portfolio, but buy-writes often underperform stocks in rising markets,” according to the CBOE. “Buy-write strategies have an added attraction to some investors in that buy-writes can help lessen the overall volatility in many portfolios.”

There are currently three available buy-write funds to retail investors:

  • Powershares S&P 500 BuyWrite Portfolio ETF (NYSEArca: PBP): The ETF has a 12-month yield of 10.2%, according to Invesco PowerShares.
  • iPath CBOE S&P 500 BuyWrite Index ETN (NYSEArca: BWV): This product is an exchange traded note, which is an unsecured debt obligation subject to the credit worthiness of the issuing bank. [What is an ETF? — Part 12: Exchange Traded Notes]
  • AdvisorShares STAR Global Buy-Write ETF (NYSEArca: VEGA): VEGA is an actively managed ETF that began trading on Sept. 18, 2012. [What is an ETF? — Part 11: Actively Managed ETFs]

For past stories in this series, visit our “What is an ETF?” category.

Max Chen contributed to this article.

This story has been updated to correct information on buy-write strategies.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.