As volatility picks up, exchange traded funds that track a covered call strategy may help investors diversify a portfolio and augment their income generation.
On the recent webcast, Using Options to Maximize Returns, Nicolas Piquard, Vice President and Options Strategist with Horizons ETFs Management, points out that according to the Tobin Q’s ratio, a ratio that compares the market value of a company to the replacement value of its assets, the markets are looking pricey.
“The S&P 500 sits at about 1.1, which means the value of the U.S. stock market is slightly higher than the replacement cost of its assets,” Piquard said. “Historically, this has signaled the market is overvalued. If earnings confidence remains strong, the Q ratio will only continue to grow.”
Meanwhile, the CBOE Volatility Index, or VIX, is hovering around its low range, revealing a complacent market. In a recent survey, the majority of financial advisors expect market volatility to pick up.
Most advisors only use traditional defensive strategies to hedge against volatility.
If volatility does pick up, investors can consider covered call ETFs like the Horizons S&P 500 Covered Call ETF (NYSEArca: HSPX), which uses covered calls with S&P 500 securities and Horizons Financial Select Sector Covered Call ETF (NYSEArca: HFIN), which tracks the S&P Financial Select Sector Covered Call Index.
These types of investments perform better in volatile conditions. Using the covered call options strategy, the ETFs sell higher strike prices on securities with greater volatility and lower strikes on low-vol stocks, capturing a greater premium.
By implementing a covered call strategy, an investor who owns a stock sells, or “writes,” call options and collects the income from the premiums paid by the buyer of the option, essentially allowing someone to collect a base fee today for their stock shares in exchange for any potential upside in the future.
Jon Najarian, Co-Founder of optionMONSTER and tradeMONSTER, explains how the call premium can also help cushion a potential decline in the markets. If the markets fall, the premium collected can help offset potential loses as compared to taking a full long position in the stock.
“They won’t fully protect you against the down side like a put option would, but the strategy allows you to be be in the ETFs or stocks you want to be in with some protection,” Najarian said.
Joe Cunningham, Executive Vice President and Head of Capital Markets for Horizons ETFs Management, explains that the covered call ETFs, HFIN and HSPX, are rules-based index-tracking ETFs that provide a monthly distribution. He also points out that these ETFs are best suited when the markets are not in a bull rally. For instance, in August, when stocks sold off, the covered call strategies picked up some of the volatility.
Financial advisors who are interested in learning more about the covered call strategy can listen to the webcast here on demand.