Need Income? Think Calls

Posted on: June 27, 2011 in: Canadian Equities, Options, Portfolio Strategies with 0 comments

Horizons AlphaPro Enhanced Income Equity ETF ( Ticker: HEX )


There was a time when dividends and bond coupons could make for a good steady income. No more. Yields on the iShares S&P TSX 60 (XIU-TO) are around 2.25% and on the iShares DEX Universe Bond Index ETF of mid-term bonds is around 3.8% with considerable price risk given that rates will eventually rise. For the income-hungry investor, one strategy to consider could be covered call writing.

Covered call writing strategies have been used for years to generate income, especially when equity markets are flat to slightly positive. The strategy involves selling or “writing” call options on a security you already hold in your portfolio, say the iShares TSX 60 ETF (XIU-TO).

If you sell me a September 2011 call option with a strike price of $19 on your XIU ETF for a premium of 40 cents, it gives me the right, but not the obligation, to buy your XIU ETF from you at $19 at any time before the option expires. If XIU’s market price exceeds the $19 strike price before the option expires, I could demand XIU from you and you would be obliged to sell it to me for $19.

On the other hand, if the market price never exceeds the strike price during the term of the option, then the option expires worthless and you keep the 40 cent premium. Annualized, that is about 8.6% and more than enough to make up for the miserly dividends.

There are just a handful of equity exchange-traded funds that come pre-packaged with call options. They have been around for years in the United States but two have recently arrived in Canada. In January, the Bank of Montreal launched an ETF holding the six big banks with call options on each.

To avoid such concentration, a better choice is Horizons AlphaPro Enhanced Income Equity ETF (HEX-TO). It invests in 30 equally weighted Canadian large-cap stocks and writes call options on each. Since its mid-March launch, HEX has paid 42 cents in dividends, annualized that would be an incredible 15.6% and includes the dividends on the stocks. Keep in mind that this is over just four months and cannot be extrapolated. HEX will also need to demonstrate its strategy over a longer period.

More realistically, Horizons expects its call writing strategy to generate at least 8% in excess return, with dividends in addition to that. However, even that may be ambitious: equity markets have been highly volatile since mid-March and that has inflated option premiums. From experience, a more realistic long-term target for excess return is closer to 5-6% annually.

The limited choice in pre-packaged ETFs means many investors, including ourselves, opt to select specific call options customized to specific portfolio holdings. Most major ETFs have options available: ETFs like the iShares TSX 60 (XIU-TO), SPDR S&P 500 (SPY-US) and Vanguard’s Emerging Markets (VWO-US). Even individual country ETFs like iShares Brazil (EWZ-US) and iShares Japan (EWJ-US).

There is also more flexibility in selecting specific options. Sometimes, it makes sense to sell a call option with a strike price that is much higher or “further out of the money” than the current market price or to select a three-month term instead of a one-month. We also consider the volatility of each ETF when selecting the appropriate call option. Other times, it makes sense not sell any call options at all, often after a sharp correction when markets are expected to rally.

The goal of the covered call strategy is this: generate income while keeping the portfolio intact. You can generate more income by selling options that are closer to the current market price but that risks having the option exercised and the security called away. That will happen occasionally but it should be the exception, not the rule.

Compared to the pre-packaged choices, selecting specific call options is generally cheaper but requires more vigilance and a sound understanding of options markets.

archerETF Metrix HEX
Category Cdn Large Cap
Benchmark S&P TSX 60
Total Holdings 30
52 Week High $10.10
Recent Price $9.40
52 Week Low $9.23
Avg Daily Volume 0.07 Million Shrs
Avg Daily Volume ($) $0.69 Million
Total Market Cap $58.00 Million
ETF Annual Fee 0.65%
ETF Trading Currency CAD
ETF FX Exposure CAD
Annual Volatility Not Available
Correlation to S&P 500 90.6%
Return to Risk Ratio Not Available
Use of Leverage No
Use of Futures Options
2 Year Return Not Available
3 Year Return Not Available

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archerETF offers Global Tactical Portfolio Management.

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© 2011 archerETF Portfolio Management is a division of Bellwether Investment Management, a discretionary portfolio manager registered with the Ontario Securities Commission. This report is provided for information only and does not constitute investment advice. While we believe the information to be accurate and timely, we make no claim or warranty to that effect. Please seek professional advice before making any investment decision. We may hold positions in any or all securities discussed in this report.

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