Covered Call ETFs: Less Bad While Damping Volatility | ETF Trends

Covered call exchange traded funds have underperformed in last year’s bull market rally, but the income-generating strategy has provided some downside protection in the current sell-off.

The Powershares S&P 500 BuyWrite Portfolio (NYSEArca: PBP), which is the largest ETF to follow a covered call strategy, has dipped 2.3% year-to-date, whereas the S&P 500 benchmark has declined 3.5%.

The buy-write, or covered call, strategy utilizes call options on a position to generate high income from option premiums. An investor would write, or 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.

If the underlying stock position trades below the strike price, or the set price on the call option, the option would expire and the investor pockets a premium. If the stock position declines, the investor also keeps the premium. However, if the stock rises above the strike price, the investor’s upside is capped, plus the option premium, so the covered call would underperform the stock.

Covered call ETFs typically underperform in a running bull rally as seen last year. For instance, PBP gained 8.0% over the past year while the S&P 500 rose 21.5%.

However, the covered call strategy also provided a bump in income from premiums gained, with PBP showing a 12-month yield of 6.75%. [Boosting Portfolio Income With Covered Call ETFs]

Currently, with stock prices falling, the call options would expire worthless and traders would pocket the premium, which means that investors are outperforming the stock.