Covered Call Strategies: The Global X Advantage

Published May 1, 2024

Market volatility cannot always be predicted ahead of time. If, for example, bonds were to fall in tandem with equities, some traditional diversification approaches used by passive investors might fail to provide sufficient downside protection and income potential. This can be difficult for investors who have defined income needs, such as retired Canadians, who rely on their portfolio’s yield to sustain a safe, perpetual withdrawal rate. During times of elevated volatility, an active management approach, using options writing strategies, has the potential to both enhance yield and improve risk-adjusted returns. In particular, entrusting a competent fund manager with implementing covered call overlays on attractive underlying equity indices or sectors can be a great way to harness volatility while preserving upside potential.

A call option is a derivative that gives the buyer the right, but not the obligation, to purchase 100 shares of a stock at an agreed-upon price by a certain date. See the illustration below as an example.

Options are comprised of the following mechanisms:

Investors who can sell call options assume the obligation of delivering 100 shares of the stock to the buyer if the call is exercised before expiry. In return, the investor receives a premium. A covered call is when the investor physically holds shares of the stock and then proceeds to sell a call option for every 100 shares of that stock. In return, the investor receives a cash premium, the amount of which tends to increase when:

In general, there are two outcomes for the investor who sells the covered call:

In scenario #1, the investor profits from the cash premium received but is still exposed to the downside of holding the stock. If the value of that stock drops, the investor will incur an unrealized loss that can be offset somewhat by the premium received.In scenario #2, the investor profits from the cash premium in addition to selling 100 shares of their stock to the buyer at the higher strike price. Depending on the cost basis and strike price, this can cap the investor’s potential gains if the price of the underlying stock moves sharply past the strike price.

Typically, the performance of a covered call strategy versus a buy-and-hold index investing strategy depends on the underlying macroeconomic conditions. Generally, we see:

The other use for a covered call strategy is as an additional diversified source of income to supplement traditional yield-generating assets, such as corporate bonds. With further interest rate hikes anticipated, rising inflation, and increasing bond yields, fixed-income assets may not provide income investors with a desirable risk-return profile.

A covered call strategy can help mitigate this by allowing investors to harness their equity allocation to increase yield without sacrificing room for the aforementioned alternatives. This way, investors do not necessarily have to increase their fixed income allocation to increase the level of income generated by their portfolio, thus offering a more defensive posture in a rising rate environment.

For retired investors in the withdrawal phase, a covered call strategy can potentially help to ensure a perpetual withdrawal rate by offering a sufficiently high equity allocation, while providing distributions that typically exceed those of dividend stocks. This can mitigate the need for investors to sell shares, maximizing their ability to meet income needs via options premiums.

The premiums received can also be used for income, saving investors and advisors from having to sell shares if withdrawals come in during downturns. Finally, options premiums are also taxed favourably as capital gains, making this strategy tax efficient compared to interest income incurred from bond funds and competitive against rates on qualified Canadian dividends. For non-tax-advantaged accounts, covered call strategies can provide a much more tax-efficient income stream to comparatively inefficient assets like REITs or bonds.

While considered relatively elementary as an option strategy, covered calls can be difficult, costly, and time-consuming for most retail investors to implement. Investors must select an appropriate portfolio of underlying securities, have sufficient capital to purchase shares in increments of 100 and possess the knowledge to select the correct strikes, and expiry dates, and watch for excessively wide bid-ask spreads.

For investors seeking to maximize their covered call strategies, a strong understanding of the Options “Greeks”, including Delta, Theta, Gamma, and Vega, along with implied versus historical volatility is necessary as well. Once the call is sold, managing the position is more complex than just collecting the premium and letting it ride. Should a position go in-the-money, the investor must determine whether to leave it be, roll the strike price up, or roll the expiry date out, lest they risk early assignment.

A much simpler and capital-efficient approach is through an exchange-traded fund (ETF) that holds a portfolio of underlying stocks with a covered call overlay. Investors who buy these ETFs benefit from the professional expertise of a fund management team, who handles the technical end of managing a covered call strategy. In return for a management expense ratio, investors can forego having to manually execute trades and rebalance their positions, which can quickly add up in commission costs and bid-ask slippage. Difficult aspects of options trading like risk management and position sizing are eliminated in favour of a simpler buy-and-hold approach using ETFs.

Many fund managers implement covered call strategies in a mechanical, passive fashion. For example, a common approach is writing at-the-money calls with less than two months until expiry on 100% of a portfolio’s underlying stocks.

This approach does not require strong active management and may produce high premiums, but is sub-optimal for the following reasons:

Global X favours an active management approach. This means the fund managers have broad discretion to consider a variety of factors when it comes to selecting the best strikes and expiry dates to sell options at, including option’s delta, implied volatility, and macroeconomic factors. This dynamic approach is more flexible, tactical, and designed to capitalize on or limit the impact of different market conditions.

Writing calls systematically with at-the-money strikes and consistent expiry dates can give up a lot of upside potential and may cause investors to miss out on heightened premiums from surges in volatility. The Global X active management approach enables fund managers to assess option’s deltas, harness implied volatility, and capture the most time decay (theta) for the possible best asymmetrical risk-return payoffs. In addition, Global X Covered Call ETFs cap covered call overlays on no more than 50% (33% in the case of Global X Gold Yield ETF “HGY”, formerly Horizons Gold Yield ETF) of the underlying portfolio’s holdings. Compared to strategies that write calls on 100% of the underlying portfolio, Global X’s approach is designed to preserve the upside price potential of the underlying holdings. Fund managers are also capable of targeting specific individual tickers in the underlying portfolios that are experiencing higher-than-normal volatility to maximize premiums. This makes the strategy more bullish and focused on long-term appreciation versus strictly maximizing income.

Global X’s suite of covered call ETFs is designed with meaningful exposure to popular equity sectors, indices, and asset classes, like energy, gold, the NASDAQ, and the S&P/TSX 60TM Index, as an alternative to traditional index funds. With a focus on upside appreciation, the funds work to harness volatility as a way to generate supplemental income from covered call premiums.

The Global X Covered Call ETFs, except HGY (capped at 33%), write out-of-the-money calls, generally, on no more than 50% of the underlying holdings. This approach balances upside participation to ensure the opportunity to gain attractive income potential from the covered calls while lowering the risk of assignment and capping returns if the underlying stock experiences a strong upward movement. The underlying securities in Global X’s covered call ETFs represent common core or thematic portfolio holdings suitable for a variety of investors with different risk tolerances, market outlooks, and investment objectives. While the covered call overlay is actively managed, the underlying securities are passively managed according to rules-based indexing methodologies to ensure low turnover and tracking error.

DISCLAIMERS

Commissions, management fees, and expenses all may be associated with an investment in products (the “Global X Funds”) managed by Global X Investments Canada Inc. The Global X Funds are not guaranteed, their values change frequently and past performance may not be repeated.  Certain Global X Funds may have exposure to leveraged investment techniques that magnify gains and losses which may result in greater volatility in value and could be subject to aggressive investment risk and price volatility risk. Such risks are described in the prospectus. The Global X money market funds are not covered by the Canada Deposit Insurance Corporation, the Federal Deposit Insurance Corporation, or any other government deposit insurer. There can be no assurances that the money market fund will be able to maintain its net asset value per security at a constant amount or that the full amount of your investment in the Funds will be returned to you. Past performance may not be repeated. The prospectus contains important detailed information about the Global X Funds. Please read the relevant prospectus before investing.

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