Canadian covered call ETFs have proliferated with the growing demand for high-yielding products during the low interest rate environment of the past decade and especially in 2021 and 2022. Canadian ETF issues have been pumping out new products relentlessly. The trend has been driven by the current bearish sentiment, increased market volatility and the demand for income from an investor public nearing retirement. As a result, this year option-write products will see over $3.5 billion in new deposits.
These ETFs are interesting as they are representative of what makes an investment vehicle marketable. They are straightforward yet complicated enough to appear sophisticated to retail investors looking for consistent income with downside protection.
Although earning additional income on top of dividends by using an options strategy may be tempting, investors need to be mindful of the pitfalls associated with these ETFs.
Covered call ETFs sell (or write) call options on a portion of their underlying securities. They are known as covered calls because the ETF owns the stocks on which the contracts are written. A call option gives the buyer the right to purchase the shares at a specified price before a specified date.
When an ETF sells a call option, it collects a premium from the option buyer, and these premiums allow the fund to pay out additional income. The price of the option will be determined based on the difference between the stock price and the exercise price, the volatility of the underlying stock (where greater volatility leads to a higher price) and the time to expiration of the option contract (where a longer time period leads to a higher price).
In theory, covered call strategies would outperform the underlying portfolio in flat and down markets and underperform in periods of market appreciation. The strategy would be most effective when the price of the underlying security is not overly volatile. The strategy will participate in the stock appreciation up to the strike price, with the added benefit of the sold call premium. This income enhancement would reduce the portfolio’s downside in bad times.
In practice, however, call option strategies have consistently provided significantly lower overall investment return to the underlying portfolio without any material reduction in risk.
To find out why this is the case, we will study BMO Covered Call Canadian Banks ETF (ZWB). ZWB has been designed to provide exposure to a portfolio of Canadian banks while earning call option premiums. In practice ZWB writes call options on BMO Equal Weight Banks Index ETF (ZEB). This allows for a perfect comparison between the covered called strategy outcome and its underlying portfolio.
ZEB has performed much better than ZWB over the last decade. This is to be expected as this lower long-term performance is supposed to be traded for downside protection in bad times. However, even in times of market distress, ZEB has done better. Both its maximum drawdown and worst year performance are better than ZWB’s.
Upon closer examination, there are four main reasons for this underperformance.
1. Opportunity cost for not participating in the underlying security’s gains
The covered call writer does not fully participate in a stock price rise above the strike. In the event of a substantial stock price rise, covered call will incur a substantial opportunity cost. Given that markets tend to rise over time, this opportunity cost will only compound over time.
2. Options pricing mechanics
As volatility increases, the prices of all options on that underlying - both calls and puts and at all strike prices - tend to rise. This is because the chances of all options finishing in the money likewise increase. This means that in order to increase income from options premiums, the option writer has to increase his/her opportunity cost.
3. Return enhancement does not translate into downside protection
Selling covered calls should not be viewed as downside risk management as downsize risk does not change materially versus being long the underlying portfolio. One would manage downside risk by purchasing puts. Selling calls is mainly a return enhancement.
4. High cost of implementation
Covered call strategies are burdened by high trading costs that exert an additional drag on performance. Trading costs are not included in the MER but are broken out separately in the trading expense ratio, or TER, of covered call ETFs.
One attractive feature covered call strategies have for Canadian investors is the tax treatment of option premiums. Income from investments in call and put options is taxed as a capital gain which is lower than the tax on interest. However, income from the sale of call options in the States is usually taxed as a short-term capital gain which does not benefit from any special tax rate. Instead, these gains are taxed as ordinary income. Canadians investing in US covered call strategies will be taxed as if they received regular income.
FAQs
A covered call strategy isn't useful for very bullish or very bearish investors.3 Very bullish investors are typically better off not writing the option and just holding the stock. The option caps the profit on the stock, which could reduce the overall profit of the trade if the stock price spikes.
What are the problems with selling covered calls? ›
Disadvantages of a covered call
Trading away all the stock's upside. One of the reasons you likely own the stock is for its potential to rise over time. By setting up a covered call, you're trading this upside until the option's expiration. If the stock rises, you lose a gain that you could have earned.
Why am I losing money on a covered call? ›
Losses occur in covered calls if the stock price declines below the breakeven point.
What is the catch with covered calls? ›
A covered call can compensate to some degree if the stock price drops, the short call expires OTM, and the premium received from the short call offsets the long stock's loss. But if the stock drops more than the premium received from selling the call option, the covered call strategy begins to lose money.
Does Warren Buffett use covered calls? ›
Covered Call Strategy: Buffett was known to employ a covered call strategy, which involves selling call options against stocks he already owns. In this strategy, Buffett writes call options on his existing holdings, allowing him to collect premiums while retaining ownership of the underlying stocks.
Can I lose money selling covered calls? ›
Losses occur in covered calls if the stock price declines below the breakeven point. There is also an opportunity risk if the stock price rises above the effective selling price of the covered call. Options trading entails significant risk and is not appropriate for all investors.
Is there a downside to covered calls? ›
With covered calls, you can earn a relatively small amount of income. At the same time, you also have to bear the risk of any downside from that stock. Thus, when you're involved in a covered call, there is a potential for you to incur lopsided returns. You may end up trading away all the stock's upside.
How do you sell covered calls successfully? ›
Tips on how to sell covered calls
- Don't sell a covered call on a stock you intend to hold on to. ...
- Don't sell a covered call on a stock you would want to own yourself. ...
- You should sell at-the-money call options. ...
- Search for shorter tenor-covered calls to sell. ...
- Keep calm if a stock you wrote a covered call recently drops.
You usually wouldn't want to sell covered calls when the market is very undervalued, for example. Covered calls are a useful tool, and in the hands of a smart investor in the right circ*mstances, can be tremendously profitable.
What is the most profitable covered call strategy? ›
A covered call strategy is most advantageous when the stock rises to the strike price, paving the way to profit for the long stock position. Simultaneously, the option premium sold becomes worthless, allowing the call writer to receive the entire premium income.
How does a poor man's covered call make money? In a PMCC, ideally the short call expires worthless, but the trader has kept the premium. The underlying asset's value has progressively increased, raising the long, far-dated call option. This can contribute to the profit potential.
Are poor mans covered calls worth it? ›
A poor man's covered call is a fantastic alternative to trading a covered call. In smaller accounts, this position can be used to replicate a covered call position with much less capital and much less risk than an actual covered call. The setup of a poor man's covered call is very important.
What is the average return on covered calls? ›
Covered calls can be a powerful tool for generating passive income and reducing the risk of your investment portfolio. By choosing the right stocks and options, you can generate consistent monthly returns of 2% to 4% per month.
Can you really make money with covered calls? ›
Covered calls can be a powerful tool for generating passive income and reducing the risk of your investment portfolio. By choosing the right stocks and options, you can generate consistent monthly returns of 2% to 4% per month.
Are covered calls too good to be true? ›
Covered calls are not too good to be true, simply because they come certain limitations. Covered calls let a trader with an existing long position in a stock/portfolio earn income, thereby improving the income yield, or alternatively reducing the cost basis of the stock/portfolio.
How does a poor man's covered call work? ›
In a traditional covered call, an investor must buy 100 shares of stock before shorting an out-of-the-money (OTM) call option against the shares. In a poor man's covered call, investors replace the shares of stock with a deep in-the-money (ITM) long call that has a longer expiration term than the short call.
Can you beat the market with covered calls? ›
As with any investing strategy, a covered call strategy may outperform, underperform, or match the market. Generally, covered calls do best in sideways or down markets. Because selling covered calls limits the upside potential, they may underperform during times when the market is rising.
