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Understanding covered call ETFs

The major benefits to a call writing strategy is to provide a higher current income and a better overall risk adjusted return.

The optimum term to write a call appears to be between 1-2 months and a few percentage points out of the money. The time decay of an option is called theta and as the chart in this video shows, the rapid decay in time value occurs within the last few weeks before expiration.

Looking at long-run average returns and the normal distribution of returns, we can see that writing a 1 month option at 5% out of the money has an extremely low probability of getting called away. Ideally, we do not want to see positions get called in a strategy like this. As we can see by the illustration and table of 4 phases of market cycles, the covered call strategy works well most of the time. As we pointed out in last week’s educational segment with BMO, even over shorter periods of time, the covered call strategy underperforms during strong short rallies too.

In these tables, we see the years where the strategy performs poorly. Here is a rule of thumb for investors who want to use these ETFs. If you expect the market to correct temporarily by 5% or less, keep the covered call strategy ETFs. If you expect a 5-10% correction, it is a tougher call to make. It really depends on how long the decline takes, but you should probably stay long the ETF. If you fear a 10% or more correction, that you should simply sell, because odds are you can sidestep at least some of the decline and buy the ETF back at some point cheap than holding it through the decline.

If you expect a modest 5-10% positive year for the market, then the covered call strategy still probably outperforms. But if expectations is for a bigger than average type of year, say 10% or higher, odds are the covered call strategy underperforms the equivalent ETF. For the Horizon’s ETF family, the covered call ETF for the TSX 60 is HEX versus the regular TSX 60 HXT. For the US market, use HES for the covered call strategy and HXS for the regular strategy.

Always keep trading costs in mind with an active asset allocation strategy.

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