By Philip van Doorn
Covered-call option strategies increase payouts and provide downside protection.
How high is high, when it comes to dividend yields?
For investors who need income, standards have changed. Long gone are the days when you could enjoy a 5% yield on a tax-exempt bond with a high credit rating.
All is not lost. Investors holding stocks can make use of covered-call strategies to provide additional income as well as downside protection. That strategy is described below, along with examples of two ETFs that can make it much easier to to use the strategy with a diversified portfolio.
Looking beyond Treasurys
Mark Grant, Janney Montgomery Scott's chief investment strategist for fixed income, summed up the unfavorable environment for bond investors in his "Out of the Box" email Feb. 16: "The year-over-year CPI Inflation rate is currently 1.4%. The Bloomberg U.S. Treasury Index, with a duration of seven years, currently yields 0.718%, which shows an actual loss of 68 basis points to Inflation."
Some investors look for income from preferred stocks, but most of those are trading at tremendous premiums to their par values, which means when they are redeemed by the issuers, investors who have paid those premiums will take significant losses.
Grant suggests using "carefully selected closed-end funds, and some exchange traded funds."
In the following discussion about fund dividend payments, the word "distribution" is used, because the income investors draw from the investments isn't only dividends. For the ETFs described below, the monthly distributions include premiums from the sale of call options.
You or your investment adviser need to be careful with closed-end funds to understand how high they may be trading when compared to their net asset values and also because many will return your own capital to you as part of the distribution. That may not be a bad thing, as it can keep a closed-end fund manager from cutting the distribution temporarily, or there may be tax advantages to the capital return. But the return of capital comes out of the NAV, which means over time, a continual return of capital will cause the share price to decline. All of this may still work out to a good total return, but it may be difficult to remain comfortable while watching your share price fall.
How covered-call options work
An investor who purchases a call option can buy shares of a stock or ETF for a specific price until the option expires. A covered-call option is one that you sell when you already own the shares.
Let's say you buy shares of a $100 stock that has an attractive dividend yield and you are confident the company will be able to maintain or raise the dividend. Let's also assume that although you like the company, you would be willing to let the stock go for $110 a share. You can sell an option to another investor allowing them to purchase your shares for $110 (the strike price) by a certain date. You receive a premium for selling the option. If the stock never rises sufficiently above $110 for the option buyer to exercise it before the option expires, you keep the premium and your shares, the dividends continue to flow and you are free to sell another option.
If the price rises high enough for the option buyer to exercise it, you keep the premium for selling the option, plus your profit on the sale of the shares, plus the dividends you earned in the meantime.
Ken Roberts, a registered investment adviser based in Truckee, Calif., provided an example of a covered-call option during an interview Feb. 16.
Shares of Intel Corp. (INTC) closed at $62.47 on Feb. 16, and with annual dividends of $1.39 a share, the dividend yield was 2.25%. If you held Intel at that time, you could have sold an April 16 $67.50 covered-call option, with a bid of $1.64.
That means if the share price were to rise above $67.50 by April 16, you would be forced to sell your Intel shares. But you would have gained 8% from Feb. 16. If the share price were not to rise above $67.50, you would still own your Intel shares and would keep the $1.64 per share you earned when selling the call option, which would be "good for a two-month investment," Roberts said.
That's a tidy sum to earn in 59 days -- more than your entire annual dividend.
If you kept the Intel shares, you would be free to keep writing covered-call options until someone exercised them. You would effectively increase your yield on the shares until selling them at what you considered to be an attractive price.
You can also consider the covered calls to be downside protection, because you have repeat income from selling new options as the old ones expire.
So where's the risk? Lost upside.
In our example above, if Intel's price had doubled right after you sold the covered-call option, you would have sold the shares for $67.50. This is why it's critically important to understand that this is an income strategy. A stock with a decent dividend yield can wind up providing you with a lot of additional income. But if it pops, your gain will be modest.
Roberts said covered calls are a core strategy for his income-seeking clients.
For high-net-worth clients with sufficiently diversified accounts, individual covered-call options can work. But if a client's account is not sufficiently diversified, Roberts said exchange traded funds that use covered-call strategies are appropriate
Blue-chip covered-call ETF
An ETF can use covered-call options by tying them to individual stocks or to indexes.
An example of an ETF following the former strategy is the Amplify CWP Enhanced Dividend Income ETF (DIVO), which is actively managed by Kevin Simpson and Joshua Smith of Capital Wealth Planning in Naples, Fla.
DIVO typically holds shares of 25 to 30 blue-chip companies that "have a long history of taking care of their shareholders by paying dividends and increasing them," according to Simpson. The fund rebalances to keep all positions from exceeding 5% of the portfolio.
Simpson said during an interview Feb. 18 that he and Smith "want companies that have been increasing earnings and have free cash flow to support the dividend. We do not want them to leverage or borrow" to cover dividend payouts.
So DIVO is following a conservative growth and income strategy. It will only have a handful of covered-call positions at any time.
"They try to tactically go in and at times clip some extra income from some of these stocks. It also acts as a little bit of a market hedge," said Amplify ETFs CEO Christian Magoon in an interview. "If you see a swoon, having those calls in place gives you a bit more defensiveness over holding the stocks naked."
The fund quotes a 30-day yield of only 1.61%. However, that SEC yield includes only the part of the monthly distribution made up of the ETF's dividend income. Simpson said the objective is a total annual distribution yield of 5% to 7%, with the payout enhanced by the option premiums. Based on the most recent monthly payout, the ETF's annualized distribution yield is 5.70%. Based on the past 12 months' payouts, the distribution yield has been 5.05%, according to Morningstar, which rates DIVO four stars (out of five).
As of the close Feb. 18, the Amplify CWP Enhanced Dividend Income ETF held 22 stocks and had sold covered-call options on six of them:
As you can see, all but one of those options will expire soon. You can review how the portfolio evolves every day on the Amplify website.
Simpson said that using covered-call options to raise the distribution yield to a range of 5% to 7% is not a very high bar, which means he doesn't need to sell that many options and is more likely to hold favored stocks over the long term. Selling options on only a small number of the stocks also helps to capture more upside in a bull market, he said.
The distribution yields and total returns discussed here are after fees. DIVO's net annual expense ratio is 0.49%.
Here's a comparison of the Amplify CWP Enhanced Dividend Income ETF's total return (with dividends reinvested) with that of the Dow Jones Industrial Average for one year through Feb. 18:
So DIVO is appropriate for conservative investors who still want equity exposure and may want or need to take the monthly distribution as income. "We want to provide good market performance and cash flow as a combined objective," Simpson said.
Nasdaq covered-call ETF
Another ETF following a covered-call strategy but in a completely different way is the Global X Nasdaq 100 Covered Call ETF (QYLD). This ETF holds all the stocks in the Nasdaq-100 Index . However, it sells covered calls on the entire index. The ETF pays monthly and its distribution yield over the past 12 months has been 11.28%, according to FactSet, which rates QYLD five stars.
But it has to be understood that QYLD is an income play only -- a high income play. There is risk, of course, if the Nasdaq-100 Index falls. But when it does, the ETF keeps selling new covered-call options and the monthly distributions continue to flow.
Conversely, in a bull market you get your income but give up much of the equity upside. Here's a one-year comparison of total returns for the Global X Nasdaq 100 Covered Call ETF (after of annual expenses of 0.60%) and the Nasdaq 100:
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-Philip van Doorn; 415-439-6400; AskNewswires@dowjones.com
(END) Dow Jones Newswires
February 19, 2021 08:39 ET (13:39 GMT)
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