As the Federal Reserve is set to hike interest rates, exchange traded funds that track a buy-write strategy could outperform the broader equities market.
“The macro and market drivers that made Buy-Write an effective investment strategy are pushing their way back to center stage after half a decade in the wings,” according to Nicholas Colas is Chief Market Strategist for Convergex. “Nothing works across all investing environments, of course. But as the Federal Reserve normalizes interest rate policy and the options market prices risk more in line with historical averages, this is one approach that should begin to show its relevance again.”
There are a few covered call, or “buywrite,” ETF options available. For instance, the Powershares S&P 500 BuyWrite Portfolio (NYSEArca: PBP), the largest buywrite ETF based off the S&P 500, and the Horizons S&P 500 Covered Call ETF (NYSEArca: HSPX), which also employs a covered call strategy on the S&P 500. [Covered Call ETF Generates Income, New Highs]
The Recon Capital NASDAQ-100 Covered Call ETF (NasdaqGM: QYLD) provides a covered-call strategy that targets Nasdaq-100 securities.
Additionally, the AdvisorShares STAR Global Buy-Write ETF (NYSEArca: VEGA) employs a covered call strategy through global stocks ETFs, including about 4.5% in emerging markets and 6.3% in developed EAFE countries, along with some international bond exposure.
With yields on benchmark Treasury bonds ticking higher on higher interest rate speculation, buy-write ETFs have been outpacing the broader market. For instance, PBP rose 5.8% and the BMX, an index of the S&P 500 and covered call position, increased 4.3% year-to-date while the S&P 500 gained 3.6%.
The covered-call options strategy allows an investor to hold a long position in an asset while simultaneously writing, or selling, call options on the same asset. Traders would typically employ a covered-call strategy when they have a neutral view of the markets over the short-term and just bank on income generation from the option premium.
Consequently, the buy-write strategy produces some attractive yields. For example, PBP has a 3.39% 12-month yield, HSPX has a 3.3% 12-month yield and QYLD has a 9.74% 12-month yield.
Ibbotson Associates has also found that the BXM has outperformed the S&P 500 during last period of rising rates, and the BMX performed at a much lower volatility. [Options-Based ETFs Generate Better Risk-Adjusted Returns]
In a flat market condition, the trader would use the buy-write strategy to generate a premium on the option. If shares fall, the option expires worthless and one still keeps the premiums on the options. However, the strategy can cap the upside of a potential rally – the trader keeps the premium generated but any gains beyond the strike price will not be realized. Consequently, in an easy-money fueled stock market rally, the buy-write strategy has underperformed the S&P 500.
“Through a market cycle, Buy-Write essentially replaces the long term positive returns of the equity market by collecting the premium imbedded in options pricing,” Colas added. “Remember – by writing a call at-the-money you are essentially foregoing any capital gain from the equity itself.”
For more information on the covered call strategy, visit our buywrite category.
Max Chen contributed to this article.