In a rising interest rate environment, investors are using covered call exchange traded funds as an alternative way to generate income, and with the equity rally slowing down, the strategy could grab more attention.
By utilizing a covered call strategy, an investor who owns a stock sells call options, and collects the income from the premiums paid by the buyer of the option. Covered call writing is a method for generating additional income from a stock portfolio. It has been used to enhance yield while reducing volatility.
“Since out-of-the money options have monetary value due to the time and volatility components priced in the options contracts, the covered-call portfolio gets to keep that money, in addition to any dividends, if the options expire out-of-the-money,” writes Ivan Martchev, a research consultant with institutional money manager Navellier and Associates, for MarketWatch. “That harvested yield can enhance the income from dividends substantially, hence, the increased investor interest.”
However, in the recent runaway stock rally, with the S&P and Dow both hitting new all-time highs, stocks in a covered call strategy go “in-the-money” and get called away – the contract is eliminated due to obligatory delivery, which can cause the investor to miss out on potential gains.
“Such a relentless rally poses a peculiar challenge for running an income-enhancing strategy like covered calls,” Martchev added.
Investors can choose from a number of covered call, or buywrite, ETFs. For instance, the passively indexed PowerShares S&P 500 BuyWrite Portfolio (NYSEArca: PBP), which follows a S&P 500 covered call strategy, comes with a 6.75 yield. PBP is up 5.8% year-to-date.