Posted on Thursday, 14th July 2011 by admin
One of the questions that we have received frequently regarding covered call etf’s is about their relationship with standard Index ETF’s. Specifically, we received this question:
“Today the market dropped 1% and while the standard ETF is down 1% (as I would expect), the covered call ETF is more or less flat. How is that possible? Isn’t the ETF long the same stocks?”
Great question. I think it’s important to understand how Covered Call ETF’s work in order to understand this. For example, if you owned for 100$ worth of stock, here is what it looks like:
Standard ETF: You own $100 worth of shares
Covered Call ETF: You own $100 worth of stock and have sold call options on those stocks. Let’s imagine that the value of those calls is $7. You would also have $7 worth of cash from those sold options ($100-$7+$7)
In both cases, a drop of 1% will result in a loss of more or less $1 in the value of the stocks. However, depending on the time left to expiry, movements in volatility and other factors, the value of the options sold might diminish by close to $1. In such a situation, the Covered Call ETF would in fact be flat!
You would now own $99 in stocks, $6 of sold options and $7 in cash ($99-$6+$7).
Typically, the options will not offset the entire movement from the stocks but in almost all cases, it will diminish the impact. Why? Call Options move in the same direction as stocks all other things being equal so when stocks go up, the options will as well. Since you sold them, it will take away gains from your stock.
Is Less Volatility A Good Thing?
Generally, since investors are risk averse, having more stability is seen as a good thing. However, it will always depend on the actual return of the Covered Call Strategy. In the end, it really depends on each investor but if getting additional income and less volatility in your portfolio is something that interests you, Covered Call ETF’s might be just what you are looking for.
Posted in Investment Talking | Comments (0)
