The recent market swings show that the aging bull market rally is susceptible to sudden extreme bouts of volatility.
Nevertheless, investors who are worried about further risks may turn to alternative strategies that exhibit lower correlations to traditional assets such as exchange traded funds that track buy-write or covered call strategies to generate attractive yields if markets continue to slowdown in the year ahead.
Covered call strategies can potentially augment a portfolio during periods of heightened volatility. The covered-call options allow 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 gather income from the option premium. While these buy-write ETFs may not produce any phenomenal price returns compared to the broader equities markets, their underlying option strategy helped them generate outsized yields.
During volatile conditions, the level of premium that can be generated on call writing also typically increases. This additional premium could diminish the volatility of the investment compared to non-covered call strategies. The options premium helps serve as both a buffer and a measure of downside protection during market selling.
If the markets stay within range or are stuck trading in a more sideways action, investors would use the covered call strategy to generate a premium on the option or bank on the yields generated. If shares fall, the option expires worthless and one still keeps the premiums on the options.
However, potential investors should keep in mind that the strategy can cap the upside of an ongoing rally. The trader keeps the premium generated but any gains beyond the strike price will not be realized. Consequently, in a stock market rally, the covered call strategy has underperformed the equities market.
Covered call strategies can create an alternative to current income investments and even complement a traditional portfolio of stocks and bonds. These types of options strategies are designed to offer investors with potential monthly income while seeking to lower the risk profiles of a variety of major index exposures.
An investor can look to something like the Horizons Nasdaq 100 Covered Call ETF (NasdaqGM: QYLD) to capture a covered-call strategy that targets Nasdaq-100 securities. The NDX call that is written will have about one month remaining to expiration, with an exercise price just above the prevailing index level, or slightly out of the money. QYLD has a 0.60% expense ratio and generated a 9.09% 12-month yield. The ETF is down 0.1% year-to-date and 12.4% higher over the past year, compared to the Nasdaq Composite’s 2.3% gain so far this year and 20.7% rise in the past year.
Additionally, the Horizons S&P 500 Covered Call ETF (NYSEArca: HSPX) also employs a covered call strategy on the S&P 500. SPX call that is written will have a one month remaining to expiration, with an exercise price 2% above the prevailing index level, or 2% out of the money. HSPX has a 0.65% expense ratio and a 3.61% 12-month yield. The ETF is down 2.9% year-to-date and gained 8.1% over the past year.
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