Option strategies in ETFs act as a buffer during volatile markets

Apr 20th, 2018 | By | Category: Alternatives / Multi-Asset

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By Horizons ETFs US.

Volatility ETFs Horizons Covered Call

Covered call strategies may provide some downside protection in falling markets.

It is to no surprise that the market would face a slight correction in the early months of 2018. The downturns experienced in February increased investor concerns and fuelled a wide range of speculations on what’s to come for the remainder of 2018.

As we move further into the remainder of the year, investors are taking a closer look at new strategies that can be used within portfolios that may help protect against potential drawdowns and possibly increase income in volatile environments. This new focus on protection and income have many looking at options and option strategies through the use of ETFs.

Covered call ETF use in a portfolio

Advisors and investors typically use covered call ETFs to access the funds’ institutional-quality options management and monthly distributions, some or all of which have included a return of capital. Investors are using ETFs, such as the Horizons NASDAQ 100 Covered Call ETF (QYLD US) and the Horizons S&P 500 Covered Call ETF (HSPX US), in an effort to enhance the yield and risk-adjusted metrics of a portfolio. Attributed to the recent spike in market volatility and the growing need of baby boomers to generate income, investors should consider covered call ETFs.

Through the use of covered call ETFs, investors may benefit from the income that is generated without the retail expense or expertise needed to trade options on a monthly basis. The expense ratios of these covered call ETFs are far less than the annual trading costs associated with running a monthly covered call strategy.

After the heightened volatility in February’s market, the experts at Horizons ETFs US decided to take a practical examination at the potential benefits of employing a covered call ETF into one’s portfolio. Horizons’ QYLD ETF was recently put to the test and compared against the Nasdaq 100 Index throughout various dates in February and March, which is where we discovered an outperformance of QYLD against the Nasdaq 100 as the market began to sell off. Historically as volatility rises, so too does the level of premium that can be generated on call writing. This additional premium could potentially reduce the volatility of the ETF; however, covered call writing can limit the upside potential of the underlying security.

Creating a covered call position

Traditionally used by traders and institutional investors, we believe ETFs that use covered call strategies are gaining attention with retail investors and advisors who are seeking alternate ways to source income. A covered call position is created by buying, or owning, stock and selling a call option on a share-for-share basis. In return for the sale of the call option, the fund receives a premium, which can potentially provide income in sideways markets and limited protection in declining markets. However, the fund is giving up its potential profit if the stock rises above the strike price of the call. The call premium can increase income in neutral markets, but if the market goes up, the seller of the call is obligated to sell their stock at the predefined strike price on the expiration date of the call option.

In a time of uncertainty around rising interest rates, rate sensitivity of covered call strategies may be somewhat mitigated. These strategies derive the majority of income from an options’ premium, which is directly linked to market volatility. This can potentially provide dividend income with less correlation to inflation’s impact. Covered call ETFs that use index options are specifically designed to follow strategies that offer investors a potential monthly income and a measure of downside protection, which can ultimately assist an investor’s overall portfolio construction.

Source: Horizons ETFs.

As show in the above graph, one can clearly see that historically, the options’ premium helped to serve as a partial buffer and measure of downside protection. It can also be seen on 5 February that the Nasdaq 100 was now down in excess of the premium received; however, it appears the outperformance of QYLD in this time frame was directly attributed to the buffering effect of the market premiums received by the fund.

Covered call strategies allow for equity exposure with an embedded potential measure of downside protection in the event of a market selloff. While income from premiums and downside mitigation are the core goals of a typical covered call strategy, investors need to take into account that covered call ETFs trade off the possibility of an unlimited upside for potentially higher income and less volatility.

The ETF landscape continues to grow, allowing investors and advisors to build more robust and institutional quality portfolios. We feel covered call ETFs are a prime example of how the industry is moving towards more sophisticated strategies that can be easily implemented into an investor’s portfolio. These types of innovative products and strategies may continue to grow in popularity due to increased investor demand and advancement across the ETF landscape.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)

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