Recently, we have done multiple posts on high yielding asset classes that income-seeking investors can utilize in their portfolios. Today, we will dive a bit further into a group of income generating ETFs that are more of a strategy than an asset class.
What is a Buy-Write Strategy?
Buy-write strategies, also known as covered calls, involve buying a stock (or ETF) and selling a call option with a strike price generally at or above the current price of the stock. If the stock price rises above the strike you are able to cover the option with the stock you own; if the stock price decreases or stays flat, the option expires worthless. Either way, you get to keep the option premium, which provides a source of income and leads to reduced volatility relative to owning just the stock.
This process generally requires more work than the average retail investor is willing to put into a strategy: your account must be set up for option trading, trading options on a basket of stocks takes time and the options must be rolled over when they expire. However, there is an assortment of ETFs that implement this exact type of strategy, such as the PowerShares S&P 500 BuyWrite Portfolio ETF (PBP), the Horizons S&P 500 Covered Calls ETF (HSPX), the iPath CBOE S&P 500 BuyWrite Index ETN (BWV), and the Recon Capital NASDAQ 100 Covered Call ETF (QYLD).
PBP, HSPX, and BWV all own and write their options on the S&P 500. PBP sells slightly out-of-the-money (OTM) S&P 500 index call calls, HSPX sells calls that are further OTM and on the individual stocks, and BWV is implemented as an ETN. QYLD trades using the NASDAQ 100. Out of the four, PBP has 12x more assets than the next biggest fund.
Besides the differences in how these ETPs implement buy-write strategies, they are also taxed differently. Unlike most equity ETFs, distributions from certain buy-write ETFs may be taxed like futures (60% long-term capital gains and 40% short-term capital gains), depending on whether the ETF sells index options or options on the individual stocks. BWV’s distributions are taxed at the ordinary income rate since it is an ETN, but this is no different the most bond ETFs. A conservative approach for comparing buy-write ETPs to other income generating ETPs is to assume the worst case – the ordinary income tax rate. Differing tax treatments become a nonissue when the investments are held in a tax-advantaged account.
A Simplified Buy-Write Strategy
To understand how these strategies work, let’s look at a simple buy-write strategy on the S&P 500 ETF (SPY). In our portfolio, we will hold shares of SPY and an equal amount of short call options.
To simplify things further, we will use the total return price of SPY as the price for the strategy. We will price the call options using the Black-Scholes formula with the VIX as an estimate of the volatility and the federal funds rate as the risk-free interest rate. We will rollover the call options on the third Friday each month when option contracts expire. On that day, we settle any currently outstanding call options and sell a new one-month call option. Selling the option generates a premium payment but does not change the portfolio value since we are now short the option. The proceeds from the sale are used to purchase more shares of SPY along with calls to cover it. We will assume an annualized fee of 75bps on each rollover date to account for some of the costs of running the strategy (or owning the buy-write ETF).
The following graph and table show the total return (i.e. reinvesting the proceeds from the option sales) and performance statistics for strategies that set the option strike price at either a fixed fraction above the current stock price or a fraction that is a set percentage of the volatility.
|SPY||0%||2%||4%||10%||25%||50% of VIX||75% of VIX|
|Sharpe Ratio (rf = 0)||0.62||0.98||1.10||1.05||0.75||0.59||1.04||1.06|
|Ann. Return to Max Drawdown||0.17||0.28||0.35||0.35||0.23||0.16||0.35||0.33|
Based on these results, we notice that:
- The fixed percentage strike price strategies performed better when the calls were written slightly OTM.
- Writing calls deeper OTM sacrifices less on the upside but generates lower premium. This is particularly illustrated in the 25% strategy, where you are paying the fee for essentially just owning the stock.
- Even a strategy with calls written at-the-money (ATM) increased the return and reduced the volatility compared to simply owning SPY.
- Setting the strike price as a percentage of the VIX led to risk-adjusted returns similar to the 2% and 4% fixed strategies. (The average monthly VIX over the period was approximately 6%.)
Another way to analyze the strategies is to look at how often the calls expired in-the-money (ITM).
|0%||2%||4%||10%||25%||50% of VIX||75% of VIX|
|Frequency of Exercise||64.6%||44.0%||21.0%||2.3%||0.0%||37.7%||22.2%|
|Average Loss of Upside||-3.3%||-2.4%||-2.2%||-1.5%||0.0%||-1.9%||-1.5%|
|Average Annual Premium||28.8%||18.5%||11.6%||3.0%||0.3%||14.9%||10.2%|
As the strike price was set higher, the call option was exercised less, and when it was exercised, less upside was sacrificed. However, higher strike prices correspond to lower option premiums. An interesting fact is that the dynamic nature of the “50% of VIX” strategy allowed it to generate higher premiums with less upside sacrificed compared to the static 4% strategy.
Moving Toward the Real World
In reality, an options contract would be sold on 100 shares, but the results could be scaled accordingly. The option prices would also not likely correspond exactly to our values calculated using the Black-Scholes formula. We used the VIX as an estimate for volatility over the next month. While this is apt when the option is a month from expiry, using it to price the option for time periods less than a month is a likely source of error. Additionally, since the VIX is calculated using a range of strike prices, the volatility for our strike prices could be substantially different, depending on how implied volatilities change over different strike prices (think of the volatility “smile”). At-the-money options would generally have a lower implied volatility than the VIX, which likely explains for the high premiums seen in the 0% and 2% fixed strike strategies.
Nevertheless, this simple buy-write strategy illustrates how the volatility and maximum drawdown can be reduced through the premium payments from the call options.
Investors should always understand what they are investing in; investing in something you do not understand means that you do not fully understand the risks. There will often be risks that even the most informed investor can underemphasize, but knowing market environments in which the strategy will out-/under-perform is a step in the right direction. We hope that this post has shed some light on how buy-write strategies are affected by the parameters used in their construction.
While buy-write strategies can be a great way to increase portfolio income, especially in a low and rising rate environment (stay tuned for more on this in a future post), they can lag significantly during strong bull markets, especially in bull markets with low volatility. Volatile markets are generally good for buy-writes because they prop up the option premiums. Higher option premiums imply more income. Ultimately, buy-write strategies may be a good source of income diversification as long as one is aware of their highly path-dependent nature.
Note: Newfound does not currently utilize any buy-write ETFs in its strategies but may choose to do so in the future. Newfound encourages investors to seek the advice of a financial advisor as the appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives.
If you are interested in learning more about other income generating asset classes along with a discussion on how they may perform in a rising rate environment, check out our previous posts on Bank Loans, MLPs, Convertibles, and Preferreds.