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A buy-write strategy primarily aims at outperforming the underlying asset class in a relatively short term horizon. It actually involves having a short term neutral to slightly bearish outlook in the underlying and seeks to earn a decent yield on holding long positions in the same security.
This happens because the strategy involves selling slightly out of the money call options for the underlying asset. The money received by selling the call options can serve as a yield for putting up this security as collateral.
In any case the strategy limits the otherwise unlimited downside risk of selling call options and at the same time enables an investor to earn cash flow streams that they otherwise would not have been able to access (read 5 Worst Performing ETFs So Far in 2013).
If the underlying trades in the neutral territory or even plummets significantly until expiry, then the option expires without being exercised by the buyer of the call option, and the investor gets to keep the premium. In this case, the investor would have outperformed the asset class in terms of total returns primarily thanks to the income generated by selling the call options.
However, this strategy primarily being a hedging technique, would significantly cap the upside potential when the underlying asset soars in value. In this case, the buyer of the call option would exercise the option and the seller of the option has to sell the asset on the price agreed upon i.e. the strike price thereby foregoing the differential between the current market value and the strike price (see Is This a Better Large Cap ETF?).
Nevertheless, the strategy does have some potential, especially if markets fail to break out even higher from here. For investors subscribing to this view, implementing this technique in basket form with the following ETF can be an interesting choice:
The PowerShares S&P 500 BuyWrite Fund (PBP) was launched in December of 2007, and provides a broad exposure to the U.S. equity market with a focus of a ‘covered call’ strategy in the S&P 500 Index.
PBP tracks the CBOE S&P 500 BuyWrite Index before fees and expenses. The index measures the theoretical performance of a covered call strategy on the S&P 500 index by writing at- or out-of-the-money call option, listed on the Chicago Board Options Exchange (CBOE) which is due for expiry the following month (read 2 Forgotten REIT ETFs to Buy Now).
The ETF has an annual yield of 3.12% mainly due to the premium received by writing the call option, a significant amount of which is reinvested. The PBP ETF has an expense ratio of 0.75%.
This ETF is appropriate for investors seeking high levels of current income and a hedged exposure to the large cap U.S equities. PBP is an interesting option, given the present volatility in the markets.
The product provides a steady stream of cash flows to investors, along with a decent protection of invested capital. However, the ETF deals in derivative products which may not be suitable for all classes of investors (read Bet on Rising Dividends with This Financial ETF).
The ETF has provided investors with decent returns although it has significantly lagged behind its parent S&P 500 Index. The ETF has an annualized return of 5% compared to the S&P 500 Index returning 13.96% for a one year period as of the end of the first quarter.
Given this, investors definitely need to assess their view for the broad market before investing in this product. Clearly, the fund will lag significantly during boom times, while it will be a very interesting choice in flat or declining markets, especially for investors seeking extra income in today’s low rate environment.
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