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Covered Call ETFs - Strategy Overview

Covered Call Option Strategy

A covered call option strategy is implemented by selling a call option contract while owning an equivalent number of shares of the underlying stock. This is generally considered to be a conservative strategy for the seller because it decreases some of the risks associated with stock ownership while providing additional income from the option premiums earned, however, it caps upside potential on stock price increases above the strike price.

Income Consideration: A covered call option strategy allows the seller to generate income from the call option premiums, in addition to receiving any dividend income from the underlying stocks.

First Asset's 25% Covered Call Strategy

An option "contract" consists of 100 shares of the issuer in question, so in order to write on 25% of the shares of a specific company, a First Asset portfolio implementing this type of covered call strategy must own at least 400 shares.

As an example, consider a portfolio that holds 400 shares of ABC Co. at a current price of $50, for a total value of $20,000. To implement a 25% covered call strategy, the portfolio writes call options on 100 ABC Co. shares (one contract). These "at-the-money" call options (exercise price is equal to current stock price of $50) expire in 30 days and are valued at a premium of $2.00 per contract; thus the portfolio receives $200 as the option premium or purchase price. The balance of the portfolio (75%) is considered uncovered and thereby entitled to all of the potential capital appreciation.

Payoff without exercise: If the stock price remains at $50, the call option contract will not be exercised by the purchaser and the portfolio benefits from the premium received. The new portfolio value is $20,200 ($20,000 portfolio value plus $200 option premium)

Break-even point: If the stock price drops to $49.50, the calls will not be exercised by the purchaser, and the portfolio value has dropped. The new portfolio value is $20,000 (400 shares at $49.50 + $200 option premium) which is the break-even point. The portfolio will devalue at any stock price below $49.50.

Payoff with exercise and capital appreciation: If the stock price rises to $51, the calls will be exercised by the purchaser, eliminating the benefit of the rising stock price on 25% of the portfolio (ie: you forgo $100 in capital appreciation only on those "called" shares of ABC), but the portfolio still benefits from the premium received and the increase in value of the other 75% of the "uncovered" shares of ABC. The new portfolio value is $20,500 = ((300 uncovered shares of ABC * $51) + (100 shares sold or exercised * $50) + ($200 option premium)).

Call Option Investing Scenerios: For illustrative purposes only
Option Basics

An option is common form of a derivative. It's a contract that gives one party (the purchaser or option holder) the right, but not the obligation, to perform a specified transaction in a specified stock with another party (the seller or option "writer") according to the specified terms of the contract and within a specified period of time.

Each option contract has a stated exercise or "strike" price, which is the predetermined price at which the purchaser can exercise their option, their right to buy or sell, the underlying stock from the seller.

The option contract will also have a set expiration date, which is the final date that the purchaser has to exercise their option in the underlying asset.

To obtain these rights, the purchaser must pay an option "premium" price at the time the option contract is initiated. The price of the option contract will be determined based on the difference between the stock price and the "strike" price (where greater price spread leads to a higher price), the volatility of the underlying stock (where greater volatility leads to a higher price) and the time to expiration of the option contract (where a longer time period leads to a higher price).

Definitions:

  • Exercise: When the option buyer chooses to execute on the right to purchase the underlying stock according to the terms of the contract, he or she is said to be "exercising" the option.
  • Premium: The price or amount that the option buyer pays the option seller in order to enter into the contract.
  • Strike Price: This is the exercise price at which the buyer of the option can purchase the underlying stock any time up to the option's expiry date.
  • Write: Selling an option contract is also known as "writing" an option.
Impact of Market Conditions on a 25% Covered Call Strategy

The covered call option strategy is most effective in sideways to slightly rising markets. First Asset's 25% covered call strategy will capture at least 75% of the upside in a sharply rising market, and provide some downside protection in declining markets.

When the stock price rises significantly and exceeds the exercise price, the call option will move "into-the-money" and the purchaser will exercise their right to buy the underlying stock at the lower strike price. This caps the gain for the call option seller, only on 25% of the portfolio that was "covered" by this call option strategy, but the portfolio will still benefit from the premium earned.

The strategy provides limited protection when the stock price declines significantly, as the decline of the underlying stock portfolio is only partially offset by the call premium received.

Participate in Covered Calls Using ETFs

A covered call option strategy tends to be suitable for conservative investors who want to generate income and still partly protect against a decline in share price. In addition to applying this strategy to individual stocks, investors have the option to invest in ETFs dedicated to covered call option strategies. For instance, an ETF could be a portfolio of all the securities held in a particular index, with covered call options written for some or all of those securities. Thus an investor would have exposure to a covered call strategy without having to own the underlying stocks directly and write the call options.

Covered call ETFs are a convenient way for investors to participate in most of the capital appreciation potential of a basket of securities, while receiving a regular income stream from the option premiums earned and any dividend income from the underlying stocks, and also providing a degree of downside protection.

Covered Call ETF ListDistribution frequency
Canada
MXF First Asset Can-Materials Covered Call ETF Quarterly, if any
CIC First Asset CanBanc Income Class ETF Quarterly, if any
United States
NXF First Asset Energy Giants Covered Call ETF (CAD Hedged) Quarterly, if any
NXF.B First Asset Energy Giants Covered Call ETF (Unhedged) Quarterly, if any
TXF First Asset Tech Giants Covered Call ETF (CAD Hedged) Quarterly, if any
TXF.B First Asset Tech Giants Covered Call ETF (Unhedged) Quarterly, if any
Global
FHI First Asset Health Care Giants Covered Call ETF (CAD Hedged) Quarterly, if any
FHI.B First Asset Health Care Giants Covered Call ETF (Unhedged) Quarterly, if any
FLI First Asset U.S. & Canada Lifeco Income ETF Quarterly, if any

Important information about each First Asset ETF Fund is contained in its respective prospectus. Individuals should seek the advice of professionals, as appropriate, prior to investing. This investment may not be suitable for all investors. Some conditions apply. Copies of the prospectus may be obtained from your investment advisor, First Asset or at www.sedar.com. Commissions, management fees and expenses all may be associated with mutual fund investments. ETFs are not guaranteed, their values change frequently and past performance may not be repeated.

The commentaries presented are prepared as a general source of information. They are not intended to provide specific individual advice including, without limitation, investment, financial, legal, accounting or tax. The opinions contained in this document are solely those of First Asset and are subject to change without notice. First Asset assumes no responsibility for any losses or damages, whether direct or indirect, which arise from the use of this information and expressly disclaims liability for any errors or omissions in this information. First Asset is under no obligation to update the information contained herein.