Covered call ETFs
Covered call ETFs are now listed and traded on HKEX.
A covered call ETF adopts an option-based strategy called covered call strategy. It holds a portfolio of underlying assets while simultaneously writes (i.e. sells) call options on those assets.
By writing call options, covered call ETFs generate income for investors by forfeiting the upside potential on such underlying assets.
How does a covered call ETF work?
Covered call strategy involves the purchase of underlying assets and the writing (i.e. selling) of call options on the same underlying assets, in exchange for a premium from the option buyer. Call options give the option buyer the right, but not the obligation, to purchase the underlying assets at a predetermined price (i.e. the strike price) on expiry date (in the case of European style options) or at any time before expiry (in the case of American style options). The call option writer has the obligation to sell the underlying assets should the option buyer exercise the call option.
Below are some hypothetical market scenarios and how a covered call ETF (using European style options) may perform. For purposes of illustration, a single underlying asset is assumed.
Before going into the scenarios, you should be familiar with the following options terminologies regarding the moneyness of options.
- At-the-money (ATM): When the strike price is at or very near to the current price of the underlying asset. The option buyer is unlikely to exercise the ATM call option.
- Out-of-the-money (OTM): For call options, when the strike price is higher than the current price of the underlying asset. The option buyer will not exercise the OTM call option.
- In-the-money (ITM): For call options, when the strike price is lower than the current price of the underlying asset. The option buyer is likely to exercise the ITM option and receive a pay out , which is the difference between the strike price and the current price of the underlying asset.
Scenario 1 – range bound market where the price of the underlying asset is neither rising nor declining
A covered call ETF may outperform an otherwise identical ETF that holds solely the underlying asset. In this case, the call option is either OTM or ATM and will not be exercised by the option buyer (i.e. the covered call ETF does not have to pay the option buyer). The premium from selling the call option is received as income by the covered call ETF.
Scenario 2 – Bullish market where there is a continuous upward trend
A covered call ETF will likely underperform an otherwise identical ETF that holds solely the underlying asset. In this case, the price of the underlying asset likely rises above the strike price (i.e. the call option is ITM) at expiry so the option buyer will likely exercise the call option (i.e. the covered call ETF has to pay the option buyer). Although the option premium is received as income by the covered call ETF, it forfeits the potential upside of the underlying asset above the strike price, which may exceed the option premium.
Scenario 3 – Bearish market where there is a continuous downward trend
A covered call ETF will likely outperform an otherwise identical ETF that holds solely the underlying asset. In this case, the call option is OTM and will not be exercised by the option buyer (i.e. the covered call ETF does not have to pay the option buyer). The premium received from writing the call option would reduce some of the losses from holding the underlying asset.
What are the benefits and drawbacks of a covered call ETF?
Benefits
- Income generation: A covered call ETF generates additional income through the premiums received from writing the call options, whilst still provides exposure to the underlying assets up to a certain point (i.e. the strike price).
- Premium received may reduce losses in a falling market: The additional income generated from the covered call strategy may help reduce losses of holding the underlying assets in a falling market.
Drawbacks
- Cap on potential gains: A covered call strategy’s gain is capped at the premium received plus any potential upside from the underlying asset up to the strike price.
- Performance of the covered call strategy is not assured: In the case of an actively managed covered call ETF, the performance of the covered call strategy is dependent on the investment manager’s selection of call options to be written and is hence not assured.
What are the key risks of a covered call strategy?
Investors should be aware of following specific risks when trading ETFs pursuing a covered call strategy.
The following risks provide a brief overview of the risks of a covered call strategy. For further understanding of the risks relating to covered call ETFs, you are advised to refer to the associated offering documents for specific risk factors and associated disclosures. If you are in doubt, you should seek independent professional advice.
- The gain of the covered call ETF is limited to the premium received for writing the call option, plus any potential upside from the underlying asset up to the strike price of the call options written, depending on the moneyness. Gains in the underlying assets above the strike price are forfeited and may not be fully covered by the premium received.
- The covered call ETF will hold the underlying assets and therefore will continue to bear the risk of market decline. Even though the ETF receives premium from writing the call options, the premium received may not be sufficient to cover the decline in market value of the underlying assets.
- The market value of the call options (i.e. the premium) may fluctuate and may be affected by various factors including but not limited to supply and demand, interest rates, the current market price of the underlying assets relative to the call option’s strike price, the actual or perceived volatility of the underlying assets, and the time remaining until the call option’s expiration date. Such fluctuation in the market value of call options may impact the returns of the ETF.
- As the ETF will need to write additional call options to maintain its covered call exposure for additional unit creations, there is no guarantee that the identical call options will be available with the same premium or the premium available may be less favourable and the purchase of the underlying assets at prevailing market levels for the corresponding long position in the additional created units may also be less favourable.
- As the ETF will need to take a long position in the underlying assets to ensure the written call options are being covered, its ability to sell the underlying assets will be limited unless the ETF cancels out its short positions in the call options by purchasing offsetting identical call options prior to their expiry. There is no guarantee that such offsetting identical call options will be available on favourable terms or at all.
- Call options may be traded over an exchange or in the over-the-counter (“OTC”) market, and options in the OTC market may not be as liquid as exchange-listed options. There may also be a limited number of counterparties in the OTC market and the terms in the OTC market may be less favourable than exchange listed options. In volatile markets, the relevant exchange may suspend trading of such options and call options may not be written when it may be desirable or advantageous to do so.
Conclusion
A covered call strategy provides investors with additional income whilst still providing exposure to the underlying assets up to a certain point. In other words, investors give up the potential upside from the underlying assets and remain exposed to the downside of the underlying assets. Hence, it is important to consider the overall risk-return profile associated with the strategy.
You should read the product key facts statement and the offering documents for all the necessary information to make an informed decision. You should also understand your investment objectives and risk tolerance before making investment decision on covered call ETFs.
28 February 2024