Nobody understands options. Okay, that’s an exaggeration. Some people do, and they use them very effectively.
But the majority of investors have little or no understanding of puts and calls, and in most cases don’t want to be bothered. That’s too bad, because options can increase your income or protect your portfolio, with very little risk if used correctly.
Options allow you to buy or sell shares in a security at a specific price (called the strike price) within a certain time. If they aren’t exercised by the end date, they expire.
Put options enable you to sell a security at the strike price and are often used to protect a portfolio from heavy losses.
Call options allow you to buy a security at the strike price. Covered calls (meaning you own the stock yourself) are used by portfolio managers and investors to add to the cash flow in an account.
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For example, suppose you own 100 shares in EasyMoney Ltd. that are trading at $50. EasyMoney call options trade on the Montreal Exchange and a little research reveals you can sell $55 covered calls that expire in July for $1.50. That means someone is willing to pay you $150 for the right to buy your 100 shares of stock at $55 if it reaches that level before expiration. If it doesn’t, you keep the stock and sell a new option (that’s called rolling forward). As long as the shares don’t exceed the strike price, it’s steady cash flow.
Too complicated? Okay, here’s the good news. There are now some ETFs and mutual funds that will do it all for you. The managers buy shares, usually those that pay dividends, and then write covered call options to generate extra income.
An example is the BMO Covered Call Canadian Banks ETF, which trades under the symbol ZWB. As the name suggests, the portfolio is made up primarily of the top six Canadian banks – Royal, TD, BMO, Scotiabank, CIBC and National Bank. The managers then write call options against those stocks.
None of those banks has a dividend yield higher than 4.8 per cent. But the annualized distribution yield for the fund was 5.13 per cent as of April 13. The difference is the options revenue, which provides an extra boost even after subtracting the ETF’s fees and expenses of 0.72 per cent. The current monthly distribution is $0.078 per unit.
The fund has made money in every year but one since its launch in 2011, although it is down slightly year-to-date. The five-year average annual compound rate of return to the end of March was 10.68 per cent.
BMO also offers several other covered call ETFs. The best performer in the year to the end of March was the BMO Covered Call Dow Jones Industrial Average Hedged to CAD ETF, which gained 12.66 per cent. The only loser is the BMO Covered Call Utilities ETF, which was down 5.7 per cent for the period.
BMO is the leader in the covered call funds, but Manulife was the first in the field. It launched its Covered Call U.S. Equity mutual fund way back in 1990. That means it has the longest track record but, unfortunately, it is not very impressive. The fund has returned only 5.64 per cent annually since inception and has a hefty management expense ratio of 2.38 per cent. And, surprisingly, it does not make regular distributions. Covered call investors are usually interested in cash flow but this fund doesn’t provide it.
Overall, covered call funds are useful for generating additional cash but there is a downside – limited capital gains potential. If a stock does well and surpasses the strike price it gets called away, meaning you miss out on any further advances in the share price. So, what you gain in revenue, you may lose in capital gains. You have to decide where your priorities lie.
Gordon Pape is editor and publisher of the Internet Wealth Builder and Income Investor newsletters.
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