How To Profit In A Range-Bound, Choppy Market

How To Profit In A Range-Bound, Choppy Market
Theodora Lee Joseph, CFA

12 months ago6 mins

  • Covered call ETFs sell call options on a proportion of their underlying stock position, generating extra income from the price (or “premium”) of the options they sell.

  • These funds can provide higher yields, lower your portfolio volatility, and give you strategic flexibility, but they come with a cap on your potential profit.

  • Covered call ETFs work best in a sideways market with high volatility, with some of the biggest funds delivering annual yields of up to 13%.

Covered call ETFs sell call options on a proportion of their underlying stock position, generating extra income from the price (or “premium”) of the options they sell.

These funds can provide higher yields, lower your portfolio volatility, and give you strategic flexibility, but they come with a cap on your potential profit.

Covered call ETFs work best in a sideways market with high volatility, with some of the biggest funds delivering annual yields of up to 13%.

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ETFs can be a great way to diversify, and they’re becoming more and more sophisticated. Besides allowing you to gain easy exposure to a market index, some also allow you to hedge your currency or interest rate exposure. If you’re like me, and you don’t have a strong view of where the market is headed over the next 12 months but you do love high-yielding assets – then it’s time to ask yourself whether a covered call ETF could work for your portfolio. They do well when market volatility is high, with potential yields of up to 13%.

What are covered call ETFs?

To understand a “call”, you need to first understand what options are. These are contracts that allow you to buy or sell an asset at a specified price on or before the day a contract expires. “Call” options give you the right to buy the asset, while “put” options give you the right to sell the asset, regardless of whether you own the underlying asset.

And there are plenty of reasons to want to trade options. They can be used as a hedge to your portfolio, allow you to implement different strategies, or even let you collect some additional income from selling contracts. Sadly, trading options can be a little overwhelming if you have a day job that is anything other than full-time trader.

But thankfully, covered call ETFs allow you to benefit from option strategies that were once exclusive to institutional “smart money”. Simply put, these funds sell call options on a proportion of their underlying stock positions. They generate extra income from the price (or “premium”) of the options they sell. If the option is exercised by the buyer, the fund has to sell the stock that they already own in their portfolio, at the agreed-upon price (or “strike price”).

What are the advantages (+) and drawbacks (-)?

(+) Income generation. Compared to ordinary stock ETFs, covered call ETFs are unique because they allow extra income to be earned on top of any dividends from the underlying stocks. This means their yields are a lot higher than what you could get elsewhere, which is particularly important in an inflationary environment. When market volatility is high, like it is now, selling covered calls can generate significant income, since option premiums rise when volatility is elevated.

(+) Lower portfolio volatility. The income from the sale of covered call options presents a buffer against downside risk and reduces your portfolio risk compared to a similar portfolio without a covered call strategy. If stocks fall, covered call ETFs generally fall less than a traditional portfolio would.

(+) Strategy flexibility. Covered call strategies can vary depending on the market outlook. Fund managers can sell a call option with a higher strike price or different expiration date if they expect markets to trend upward for some time.

(-) Capped profit potential. The upside price potential of your portfolio is limited by the strike price of the call sold.

Covered call payoff. Source: The Options Bro.
Covered call payoff. Source: The Options Bro.

For example, let’s say you bought stock XYZ for $50, and sold a call option for $2, at a strike price of $55 which expires in one year.

If the stock price rises to $54 at the end of the year, you would have made $6 in profit.

$54 - $50 = $4 (stock price appreciation)

$4 + $2 (call option premium) = $6

If however, the stock price rises to $58 or higher at the end of the year, you would still have made a profit, but it would have been capped at $7.

$55 (option strike price) - $50 = $5

$5 + $2 = $7

(-) Limited trading ability: A fund may lose its flexibility to sell stocks on which covered call options have been sold. This becomes a more serious risk when stock markets plummet more than expected. To sell a position, the fund would have to buy back an offsetting option, which can get expensive.

When do these covered call ETFs work best?

Generally, it’s when you expect a market to be neutral or move in a sideways direction for some time, without much upside or downside potential. That’s because your gains are capped in an appreciating market, and you lose flexibility to sell your assets when markets go sharply south. These ETFs also generate the most income in a market with high volatility – since those choppy price moves drive up the premium received on selling a call option.

The best type of portfolio with a covered call strategy is one where you’re not emotionally tied to the stocks, and are able to sell the stock when the option is exercised. A covered call ETF works well because the fund manager makes the decision – relieving you of the emotional aspect of decision-making.

What are the different types of covered call ETFs?

There are many types of covered call ETFs you can invest in, since you can write calls on almost any index, sector, or stock. If you would ordinarily invest in the S&P 500, you could buy a broad-based covered call ETF that tracks your intended index. Other more-targeted types include sector-specific covered call ETFs, which allow you to invest in a specific sector of the market. If income is particularly important to you, high-dividend covered call ETFs invest in stocks with high dividend yields, and generate additional income from selling options on them – allowing you to generate yields higher than the average dividend yield you’d get from holding these stocks.

What's the opportunity then?

While investors might debate whether we’ll be in a recession in the next 12 months, and how mild a recession might be if there is one, what seems most likely is that markets will continue to be plagued by high volatility. The upside opportunity for stocks seems limited considering how far they’ve rallied this year, which could mean they’ll continue to drift sideways for some time. Both are situations where covered call ETFs tend to outperform.

To get started, you could consider using covered call ETFs as a complement to your core portfolio. And there are quite a few to choose from. For example, there’s the Global X S&P 500 Covered Call ETF (ticker: XYLD; expense ratio: 0.6%), which has a distribution yield of 12.8%, and the Global X Russell 2000 Covered Call ETF (RYLD; 0.6%), which yields 13%. Or you could seek out your own preferred version here.

Depending on where you live, you might be subject to higher taxes than long-term capital gains from holding the underlying stock, so you might want to consider holding these ETFs in a tax-advantaged account.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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