Covered Call ETFs - ZWB, HEX, etc.
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Thread: Covered Call ETFs - ZWB, HEX, etc.

  1. #1
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    Covered Call ETFs - ZWB, HEX, etc.

    The current high yield of ZWB is bound to generate some interest among income seekers.

    With this hightened interest, will come questions on this new and unique product. This thread will cover these new income generators, including:





    We'll follow their progress and question the risks and taxation implications.

    .

    Last edited by avrex; 2011-12-20 at 07:53 PM. Reason: altered title to more encompass the wider breadth of coverage call ETF products now available.

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    humble_pie thoughts

    I didn't want to lose some early thoughts/research that humble_pie has provided.

    So I've taken his quotes from two other seperate threads and merged them into this thread.

    Quote Originally Posted by humble_pie View Post
    zwb is an interesting new creature with a high yield currently around 9.5%, payable in monthly distributions.

    one highly evident caution is that the market value of the underlying banks could go down, and it would be expected that in such a scenario this fund would go down harder.

    a less evident caution is that the taxation of this lucrative 9.5% yield is not yet known, the fund being too new (inception early 2011) and having not obtained any advance ruling from the CRA.

    in the best of all possible worlds, income from a long-bank-short-call portfolio strategy will flow directly to an individual investor as a desirable combination of eligible canadian dividends plus even more desirable capital gains.

    however, we do not yet know how zwb will distribute its income for taxation in its unitholders' hands. It is theoretically possible that the flow of option income will, through the intervening mechanism of the trust, be transmogrified into ordinary income rather than capital gains. This would be most unfortunate.

    a further investigation could be justified. I might look into this myself. Presumably bmo etf fund management does hold an opinion on how it intends to classify its distrib for tax purposes in the first batch of T3s for this new fund that will be sent out one year from today.

    meanwhile, in a worst case scenario, the most dire taxation consequence would be that both dividends & capital gains will morph into 100% taxable other income. At 9% or better, even this is not a bad deal, provided one is happy staying long canadian banks.
    Quote Originally Posted by humble_pie View Post
    there are broad general "extra tax implications" inasmuch as all income is, alas, going to be taxed.

    zwb, bmo's bank covered call option etf, is so new that there is not much hard info. However the pie has been able to determine that bmo intends to pay distributions in the form of 1) eligible dividends as the greater part, and 2) capital gains in the form of ordinary capital gains plus return of capital, which is a form of delayed capital gains since ROC is used to adjust a cost base downwards.

    the above are tax-favoured forms of income. For taxable investors these are more beneficial than straight interest, other income or foreign non-business income.

    yield on this etf as of yesterday was 9.50%. There are other products utilizing a strategy of high dividend payors combined w short option selling. However, the bmo product has the simplest structure of any the pie has seen to date. Moreover, bmo is not over-paying its distribution imho, as some of the existing products are doing, esp dividend 15 with its split structure, which forces the issuer to raise new capital from time to time in order to support a somewhat outrageous dividend on the common series.

    lastly - perhaps most interestingly of all - there would be a way to collarize this etf so as to produce a guaranteed return of approximately 3.40-3.50% per annum. In other words, a far better return than any HISA available in canada; and this in the form of tax-favoured income rather than straight interest to boot. Collarization will not be perfect in the sense that there are no options available for exactly this deliverable; however buying puts on a similar product would produce an adequate collar.

  3. #3
    Senior Member Causalien's Avatar
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    Call option premium for Canadian banks are so little due to the effect of dividend and the fact that implied volatility for Canadian banks are close to nothing, that I do not think this is any different from outright holding the bank's stock.

    Take TD for example. My stock price for that bank has doubled. Whereas if I have sold a covered call, I might have limited my upside while gathering little to no premium. If the stock were to fall down two strike prices, because of the thin premium, the Covered call fund suffers the same amount of downside as my actual stock holdings.

    In writing options, the experience of the fund manager at writing options is a major factor of whether or not the fund meets expectation.

  4. #4
    Senior Member humble_pie's Avatar
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    cause i understand your views but do not agree. In your 1st paragraph you say the new fund is no "different from outright holding the bank's stock."

    here i disagree. The bmo fund's return is double that of the average dividend or more. To equal, bank stocks would have to continue to appreciate by at least 4-5% per annum, year after year. No certainty of this whatsoever.

    like any long-bank-short-call position, the bmo strategy will return approximately 9-9.5% per annum in 3 out of 5 markets, and thus it will better a plain stock position. The 3 are stable (unchanging) markets, moderately falling or moderately rising markets. Plain stock will suffer, compared to an optioned position, in stable or falling markets; and may not rise as much as the option return will offer during moderately rising markets.

    turning now to the 2 much rarer & extreme scenarios, an option strategy will not do any worse than plain stock in a market collapse; while it will equal or very slightly underperform plain stock in a fiercely strong bull market, the kind we might see only once a decade or less.

    with odds like that, and viewed from the perspective of a decade or more, the option strategy is more appealing imho.

    specifically, the bmo strategy is not quite the strategy that i favour or practice myself. I tend to sell less aggressive options, ie farther OTM. This means 1) my current cash return is slightly less than than bmo's; 2) my risk of assignment is less than bmo's; and 3) my participation in rising markets is greater. Another way of analyzing this is to say that my current return includes less actual or realized capital gains (lower option premiums) while deferring more notional or paper capital gains into the future.

    the bmo approach means selling calls that are closer to the money. These bring in more cash, which is what appeals to investors. The ATM premiums also trigger more frequent assignments.

    turning now to your TD example, the doubling in this stock occurred relatively slowly, over a fairly long period, which was the past 2 years. Yes i've held td throughout. Yes my stock has doubled. No i've never been assigned. What i did was adjust my options judiciously, from time to time, as the months & years passed. In short, i held & still hold a stock that has doubled, i've collected the dividends & i've also collected premiums from selling a succession of calls along the way.

    a relatively inexperienced option trader often assumes that he is locked into exercise if he writes a call & the stock rises. In reality, however, he will have many opportunities to adjust his position, to dance with the market.

    it's true that canadian bank options are slow, stout & ponderous dance partners. But what can one do. It's either dance with the dowagers or head south to look for the nubile young things. And i belong to the school that says rich dowager aunts like canadian banks are a mainstay in every canadian investor's family.

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    This was taken from Berman's call on BNN Feb 28, 2011:

    Since Jan 31, a few options expired worthless and they took in some premium. At this point they are writing calls that are about 5% out of the money and for only 50% of the portfolio. The ZEB holding is about 50% of the portfolio. It is their own equal weight bank ETF. They are looking to list options on this part too at some point. At the current level of implied volatility, at about 5% out of the money for 1-2 months, they can take in about 0.75% if they are good at witting of the offer side. The bid offer spread on such options can be extremely expensive. So if the basket of bank stocks on an equal weighted basis generates about a 3.5% dividend today, they need to write 3.5%-4.5% in option premium per year to keep the payout. Bottom line, it is quite achievable.

    Where these strategies underperform is in a run-a-way bull market as cost of replacing stocks called away are higher than buy and hold. Odds of a run-a-way bull in the next few years is looooowwww! It can also be tough in rapidly falling bear markets like 2008 and 2009, when volatility is exceptionally high. Option premiums are higher to be sure, but timing is extremely difficult. Bottom line, it is a nice holding to diversify a yield oriented portfolio. I will be using it for my clients.

  6. #6
    Senior Member humble_pie's Avatar
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    para 2 of the above is my point exactly. Only in a fiercely soaring bull market does the long-bank-short-call strategy somewhat underperform holding plain stock; and markets like these happen less often than once a decade. I would not describe the slow & steady rise from 2009 as being anywhere near this category.

    in other markets long-bank-short-call outperforms.

    to achieve the payout bmo is aiming for, the managers will definitely have to write calls on the equal weight bank etf that forms about half of ZWB's portfolio. In a rash of assignments this etf could be unbundled, although imho this should not be necessary, since synthetic stock positions could & should also be kept in place, at least to a certain extent.

    btw nobody has mentioned the bull in the china shop yet. What-if-disaster-prevails-&-all-the-banks-cut-their-dividends. And-in-such-a-scenario-option-premiums-will-plummet. Mind you, plain vanilla bank holders would also be pulverized ...

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    Great post!

    Great post Humble Pie and Avrex. It looks like the markets going forward will be range bound and thus, the ZWB and HEX will both perform admirably - especially if it's yield you're seeking.

    I think I'll add positions in my portfolio.

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    Very interesting information here, thanks.

    About the small liquidity and vol of the canadian option market, how will the rising popularity of those covered call ETF affect the premium collected? I would think the sudden excessive offer in call writting will quickly reduce the expected yield on these ETF, but im no option expert.

    How about a TFSA Drip on HEX for low maintenance long-term strategy?

  9. #9
    Senior Member humble_pie's Avatar
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    good idea ... but i for one don't think there will be any sudden excessive offers in bank calls.

    if one looks through open interests on mx-ca, one finds high volumes in a restricted number of underlyings. Banks are among these. Others are xiu, xeg, xfn, sometimes xgd.

    these spotty cases of high open interest indicate that institutions have taken/are taking these positions. It's been going on like that for years. So i don't believe that the addition of bmo's new etf as a seller of options is really going to put any dent in proceedings at mx-ca.

    on the contrary, more liquidity should mean better spreads for us small fry.

  10. #10
    Senior Member Argonaut's Avatar
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    The ultimate yield play would be to write covered calls on this ETF. I doubt there's a market for it, though. This is why we need mergers like the LSE-TSX to happen.. more liquidity.


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