For those who are looking for a low risk income producing investment, you have been on the wrong side of the equation for the past 3 years! In fact, both certificates of deposit and bonds show poor interest returns. Canadians even saw their high income producing income trusts reduced to Canadian REITs in 2011. So if you are looking for a steady income stream from your investments, you do not have many choices but to look towards dividend investing. Unless… yup UNLESS you have heard of the new “flavor of the month”: you can take a look at Covered Call ETFs.
Covered Call ETFs Explained for Dummies
Let’s take a quick example:
I hold a position in Johnson & Johnson (JNJ). Let’s say the stock is at $65.
Let’s say it pays a healthy 4% in dividend. (so a dividend payout of $2.60 per share)
Since I hold the stock, I can write a call option at a strike price of $66 (e.g. selling to another investor the right to buy my stock at a defined price during a specific period of time).
By selling my call option, I receive money (the investor will obviously have to pay to buy the “right” to buy the stock at a defined price). Let’s say I sell it for $0.50 for a call option that lasts 3 months.
Until the option matures (the option is a contract with a defined price, defined quantity and a defined expiry date), I keep holding JNJ and getting the dividend payouts. Therefore, I am now making an annualized rate of dividend of 7.08% ($2.60 of dividend + $0.50*4 for the sale of my Call option).
At maturity date, there are 2 possibilities:
The call is “in the money” (e.g. the stock worth more than $66.50 (the strike price + the price of the Call option). I have to give my stock to the investor in exchange of $66 (plus the $0.50 I have received previously).
The Call is “out of the money” (e.g. the stock worth less than $66.50). I keep my stock and the option matures.
If you want more information on how covered call ETFs works, I strongly suggest you go see Covered Call ETFs. This is a resourceful website that is dedicated to covered call ETFs. I have built it the same way I did with What is a Dividend.
Advantages of Covered Call ETFs
As you can see in my simple example, the major advantage of a Covered Call ETFs is to earn a higher yield on your existing investments. By selling Call options, you are “adding” yield to your overall dividend yield.
The second interesting advantage is that covered call ETFs works well in sideways or bear markets. Why? If the stocks goes sideways or drops in value, the holder of the Call options won’t exercise it. After all, who would like to buy JNJ at $66 when it’s at $64 on the market? Therefore, you keep your holdings while earning extra income (dividend + money generated from the sale of the call option).
The third advantage of covered call ETFs is that it reduces the volatility of your portfolio. Since you are earning an extra income on top of dividends, it will help you smooth the value of your portfolio. It won’t protect you from any market losses but the additional income will play the same role of the dividend payout in your portfolio. In the end a Covered Call ETF on dividend stocks will play a similar role to highest yield dividend stocks without having the fluctuation risks that come with it.
Disadvantages of Covered Call ETFs
Nothing is perfect and there is no free lunch in the finance world; covered call ETFs are not perfect either. Their major disadvantage is definitely that they won’t be spectacular during bullish markets.
If your stock keeps rising, the holder of the Call option will use its right to buy it at the strike price (which will be lower than the market price). Therefore, if you want to keep holding the stocks for its dividend, you will have to buy it back on the market at a higher price. While you will still be earning the same dividend payout, your dividend yield will be diminished.
Another disadvantage of covered call ETFs comes from their MERs. Since they require active management on top of writing calls, the fees are slightly higher than the “normal” ETFs. They are around 0.65% which becomes closer to some mutual funds.
Finally, the last issue with covered call ETFs is that it’s a product that is fairly new in Canada and we don’t have much data to analyze. Fortunately, this concern will be addressed overtime.
My Pick on Covered Call ETFs: ZWB
This is a fairly new covered call ETFs issued by BMO. It follows the Canadian Banks which are my favorite in the financial industry. The 6 banks all show strong balance sheets and pay healthy dividends already (in the range of 3 to 4%). Combined together in a covered call ETF, ZWB pays over 9% in dividends at the moment. I know that I am already heavily invested in financials (I hold NA and BNS and now ZWB) but I am convinced that the Canadian Banks will do well in the upcoming years.
You have more questions about Covered Call ETFs? Ask your questions in the comments or visit my new site: Covered Call ETFs