We don’t need to rehash all the Fed’s recent policy mistakes, but people were rightfully concerned this cycle of rapid rate hikes would ultimately lead to “something breaking.”
Thus, here we are; the failure of Silicon Valley Bank (SIVB), Silvergate Capital (SI), and the possible contagion that could lead to another banking crisis. This forced the federal government to step in and provide Silicon Valley Bank depositors a backstop, making them all whole once more.
While there is no direct impact on most businesses, it does create uncertainty over second order effects. Effects like the slowing economy and the stickiness of inflation, which have put pressure on the broader market and lead to large spikes in volatility.
It makes no sense to panic, in fact, there are probably good buying opportunities in the market now, perhaps even in the financial sector. However, there are steps one can take that not only reduce portfolio risk but also benefit from the fear.
This all springs to mind looking for ETFs that employ option selling strategies, such as covered calls or selling puts, that can help smooth out returns during tumultuous times.
A Covered Call, also known as a Buy-Write, refers to the process of selling a call option on a stock or fund that you already own.
By owning the stock, you’re “covered” (i.e. protected) if the stock rises and the call option expires in the money. If the option expires out of the money (i.e. worthless), you keep the premium you collected and still own underlying security. This provides an income stream or yield and also provides incremental downside protection as it reduces the effective cost basis of the stock.
The main drawback of buy-writes is it caps the upside or potential gains at the strike price of the options sold. If the underlying share price is above the strike at expiration the stock can be called away. Of course, an individual, or the funds we are going to look at, have the ability to adjust or ‘roll’ the call to a later expiration date and a different strike as a means of continually collecting premiums. This process can be labor intensive and forces the investor to make a decision as to when and where to roll the option.
By using an ETF that employs option selling strategies investors can save time, remove emotions, and not actively manage any kind of position other than ownership of the ETF.
Essentially, buy-write programs can provide extra income and smooth out returns for those willing to forgo some potential upside.
Here is a basic risk reward graph of buying 200 shares of SPDR S&P 500 ETF (SPY) at the current price of $388 and writing 2 contracts of the April 380 calls for $10 each.
This brings your effective cost basis down to $379, a 2.5% discount to the purchase price while still offering the potential for a 3% return over the next 32 days.
Let’s look at some specific ETFs that employ a covered call strategy.
The Invesco S&P 500 BuyWrite ETF (PBP) is based on the CBOE S&P 500 BuyWrite Index (BXM) generally will invest at least 90% of its total assets in securities that comprise the Index and will write (sell) call options thereon.
PBP and BXM adhere to similar formats, holding a long position indexed to the S&P 500 and selling a succession of covered call options, each with an exercise price at or above the prevailing price level of the S&P 500 Index and 30-day expiration. Dividends paid on the component stocks underlying the S&P 500 Index and the dollar value of option premiums received from written options are reinvested.
PBP has a low-cost expense ratio of just 0.49% and has declined by 5.99% over the past 52 weeks, which compares favorably to the SPY, down 8.2% over the same time period.
Another ETF based in the CBOE’s BXM Index is The Global X S&P 500 Covered Call ETF (XYLD) also follows a covered call or “buy-write” strategy, in which the Fund buys the stocks in the S&P 500 Index and “writes” or “sells” corresponding call options on the same index. The main difference is XYLD makes monthly distributions and has done so for 9 years running.
An interesting twist on this comes from AllianzIM U.S. Large Cap Buffer20 ETF (JANW) which employs FLEX options, which are customizable, across 12 monthly expirations to track the returns of a hypothetical investment over a period of approximately one year.
This fund seeks to provide shareholders that hold shares for the entire Outcome Period with a downside loss buffer against the first 20% of Underlying ETF losses (the “Buffer”).
The buffer is measured based upon the Underlying ETF’s share price at the time the Fund enters into the FLEX Options for the Outcome Period, which occurs on the business day immediately prior to the first day of the Outcome Period.
If the buffer works as intended, it’s expected that if the underlying ETF’s share price has decreased by more than 20% as of the end of the Outcome Period, the fund would realize losses beyond the first 20% on a one to-one basis.
This means that the fund will decrease 1% for every 1% decrease in the underlying ETF’s share price. For example, if during the Outcome Period the underlying SPY were to lose 30%, JANW is designed to lose just 10%.
JANW has a slightly higher expense ratio of 0.74%, however, it has delivered a positive 4.75% over the past year, a whopping 12.9 basis points above the SPY.
One more ETF I find intriguing, the WisdomTree PutWrite Strategy Fund (PUTW). As the name implies, this fund employs a put selling strategy to track the price and yield performance of the Volos US Large Cap Target 2.5% PutWrite Index.
Put writing has a similar risk profile as covered call, but in times of high volatility, it can produce higher risk-adjusted returns and help overall lower a portfolio’s beta or the deviation from the underlying asset.
You can use Magnifi Personal to find and analyze other funds which overlay options to help buffer your portfolio during volatile times. They include various sectors, global indices and bond funds.
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