Over the last few years there has been a dramatic increase in the number and popularity of covered call ETFs. These funds provide investors with easy-to-implement solutions for generating current income. However, these funds tend to underperform the market by a significant margin. It’s not surprising that these funds have lagged the S&P when the market has been in a strong uptrend. After all, it’s hard for any strategy with capped upside to match the market during such periods.
Over the last few years there has been a dramatic increase in the number and popularity of covered call ETFs. These funds provide investors with easy-to-implement solutions for generating current income. However, these funds tend to underperform the market by a significant margin. It’s not surprising that these funds have lagged the S&P when the market has been in a strong uptrend. After all, it’s hard for any strategy with capped upside to match the market during such periods. But, beyond a less-than-ideal environment, there are aspects of these funds – the options they sell and when they sell them – that makes them suboptimal and a few best practices you can use if you want to create a more effective strategy.
At-the-money Options
The most glaring deficiency of most covered call ETFs is that they sell at-the-money options or 50 delta options. The problem with selling at the money options is that if the underlying stock or ETF appreciates, the option seller does not participate in the upside and the only return comes from the premium generated by selling the option. A more effective strategy is selling out-of-the-money options that generate premium but also preserve some upside.
The image below is a graph of the performance of the CBOE S&P 500 BuyWrite Index (BXM) (shown in black), which sells at-the-money call options against the S&P 500 and the CBOE S&P 500 30-Delta BuyWrite Index (BXMD) (shown in green). The difference between these two indexes shown is that the 30-delta index (BXMD) sells out-of-the-money options, while BXM sells at-the-money options. If you’re unfamiliar with the concept of delta, it is the change in the price of an option due to a change in the price of the underlying; so, if an option has a delta of 50 and the price of the underlying stock increases by $1, the price of the option would rise by $0.50. At-the-money options have a delta of 50, in-the-money options have deltas greater than 50, and out-of-the-money options have deltas less than 50. As you can see, since September 2002, BXMD has roughly doubled the performance of BXM. There is no "right" answer when it comes to the question of exactly how far out of the money an option should be, but some option sellers find 30 delta to be the sweet spot between generating premium and preserving upside.
Time to Expiration
One of the major factors in the price of an option is its time to expiration. As its expiration gets closer, an option’s value declines, which is referred to as time or theta decay and works in the favor of option sellers as the value of their short option position increases. One key thing to understand about time decay is it is not linear – a one-month option will experience a higher degree of time decay in the last week before expiration that in the first week after being written.
The buywrite indexes mentioned above and many covered call ETFs sell 30-day options, which is not a bad strategy. However, an investor could earn significantly more premium by writing shorter-dated options. An at-the-money call option on the SPDR S&P 500 ETF Trust (SPY) expiring on June 6th (one week from today) is currently trading at around $5.48, while at-the-money option expiring on June 28th (four weeks and one day from today) is trading at around $11.37. So, writing four weekly options would generate $21.92 or about 92% more premium than writing one 30-day option. The trade-off is that selling options weekly is a more time-intensive strategy and a weekly writing strategy may sacrifice some downside protection.
Naïve Selling
Covered call ETFs use a naïve option selling strategy – when a short option position expires another is written on the underlying position without regard to the state of the market or any other considerations – which can mean selling an option against a position that has had a significant decline and not participating in a subsequent recovery. Someone running a discretionary strategy might decide not to sell a call if the market were heavily oversold, for example. This is more art than science and does not guarantee superior performance, but naïvely selling into down markets is a major potential performance detractor for covered call ETFs.
Covered call ETFs provide investors with an off-the-shelf strategy for income generation that is easy to implement. However, an industrious investor who is willing to put in some extra effort can likely create a more effective strategy by making a few relatively simple adjustments.
