Writing Calls Against ETFs

When most investors think about selling covered calls, they think in terms of writing calls against individual stocks. Less often we think about writing covered calls against exchange traded funds (ETFs). Too bad really, because there are some interesting opportunities in that market space.

Trading ETFs reduces the impact of company specific risk which is defined as an event that can affect a company without necessarily the sector or market. Drug trials being a classic case where the success or failure of a particular drug can impact the sponsoring company with little or no effect on the sector.

While traders are pretty good at evaluating risk in a sector or the broader market, individual corporate risks are, for the most part, unknown. Which means the option market cannot quantify these risks! And that itself is a risk because a material event can exponentially impact the value of the underlying stock.

What tends to happen is that options overstate risk within sectors and the broader market while understating risk among individual companies. Proof can be seen in the performance of the Mx Covered Call Writers (MCWX) Index.

The MCWX is a benchmark that tracks the performance resulting from the rolling sale of one month at-the-money calls against a long position in the iShares S&P TSX 60 ETF (symbol XIU). With data back to 1992 we see that the options market has regularly overstated the actual historical volatility of holding XIU.

It makes sense that index option buyers tend to overpay. There is only one decision to make; are you bullish or bearish on the market? No second guessing about which sectors will outperform or which stocks within a sector will stand out. And of course, no risk of being blindsided by a material event that could not possibly be predicted.

Another consideration is downside risk. Individual companies can go bankrupt, ETFs cannot. That zero is never the worst case scenario is a positive for the covered call strategy. Bottom line covered calls on ETFs provides better risk reward metrics.

The challenge with selling ETF covered calls in Canada is liquidity constraints on many of the names. Still there are opportunities with enough liquidity to trade. Particularly within sector ETFs. For example, you might look at writing covered calls on iShares S&P/TSX Capped Energy Index ETF (XEG), iShares S&P/TSX Global Gold Index ETF (XGD) and iShares S&P/TSX Capped Financials Index ETF (XFN).