Capturing Volatility to Be a Return Source
Market volatility has been stubbornly persistent — but does that present opportunity? Laura Tase, Director, Institutional & Advisory, BMO ETFs, outlines how investors can capitalize on volatility — and enhance their income — with covered call option strategies.Oct. 19, 2022
The importance of understanding volatility
Volatility is crucial to understanding options markets — and to identifying advantageous option-based strategies.
Behavioural science expresses itself quite clearly in an examination of historical volatility versus implied volatility. Historical volatility — or realized volatility — involves the analysis of real, hard data to determine the degree of price fluctuation of underlying securities over a particular period of time; in short, it is volatility that has already occurred. Implied volatility, on the other hand, is a projection — a calculation of how volatile markets will be going forward based on the price of an option and imbalances in supply and demand. It is volatility that hasn’t happened yet — and, as with all estimates, it is subject to the emotions of the people doing the estimating.
These behavioural factors may offer an explanation for a key concept for options traders: the historical imbalance between realized volatility and implied volatility. This imbalance makes it very attractive to sell options based on implied volatility.
Exhibit 1: Realized Volatility vs. Implied Volatility
|Cboe Volatility Index® (VIX®)|
|Cboe Short-Term Volatility (VIX9D)|
|Cboe 3-month Volatility (VIX3M)|
|Cboe 1-Year Volatility (VIX1Y)|
|Cboe DJIA Volatility (VXD)|
|S&P/ASX 200 VIX (Z-VIX)|
|S&P/BMV IPC VIX (SPBMVVIX)|
|HSI Volatility (VHSI)|
|Cboe EM ETF (VXEEM)|
As illustrated in the chart above, historically realized volatility (rightmost column) tends to exceed implied volatility (VIX). In general, when the market goes down, volatility tends to go up. This results in higher premiums and greater yield for the investor. Ratcheting up investment in option overlay strategies in higher-volatility environments therefore would be advantageous.
In general, when the market goes down, volatility tends to go up. This results in higher premiums and greater yield for the investor.
Benefits of covered call overlays
Covered call option strategies — also known as buy-write strategies — are designed to provide an investor with a tax-efficient1 dual source of cash flow: an option premium plus the dividend yield. The strategy is implemented by writing (selling) a call option contract, while owning the underlying stock. In addition to offering enhanced income, it is also considered a defensive strategy, as equity downside returns are mitigated by the option premiums.
With BMO’s suite of covered call strategies, we write further out of the money (OTM) when markets decline in order to protect the capital in case markets rebound. But we can also earn a higher premium at the same time, particularly as rising market volatility increases the value of the options contract.
Exhibit #2: Option Yield Scenario Table
Option Overlay Approach
Overlay Strategy Targets 2% - 4% in Option Premium: Approximately 50% of the portfolio is covered, consistently against the underlying portfolio.
Strategy uses OTM options > 2% OTM, and dynamically adjusts moneyness to generate the targeted income.
Prevailing market conditions, including implied volatility, will determine the ideal level of yield to target.
Option premiums are taxed on the capital account.
Source: BMO Asset Management Inc., Black-Scholes option pricing model assuming 50% portfolio coverage.
As shown above, yield increases as we write further OTM based on implied volatility. The takeaway is clear: using a covered call overlay enhances income and lowers dependence on capital gains for a positive total return.
To consider it another way — portfolios with long-only positions offer two sources of returns:
- Dividends: Stable, positive returns
- Capital Gains: Unpredictable and with variable outcomes
Strategies with covered call overlays, on the other hand, offer those two sources plus an additional one:
- Capital Gains
- Option premium – Positive but varies with volatility (when the market goes down, volatility rises, and the premium goes up)
A regular long-only portfolio has full market exposure, and the portfolio value will move fully with the stock price. When a portfolio writes options, its exposure to the market changes — often to the investor’s advantage.
Looking under the hood — three variables in BMO’s option writing strategies
There are three variables in BMO’s option-writing strategies:
- How much of the portfolio to write on: Generally, OTM call options are sold on approximately 50% of the portfolio, depending on market conditions. This provides the investor with enhanced yield while still allowing for participation in rising markets. Conversely, 100% option overlays have upside risk, as they are forced to buy positions back if the call is assigned.
- Where to write: We always write out of the money to protect capital and avoid the upside risk mentioned above. However, where we write differs according to market conditions. We sell further OTM when volatility rises, and closer to the money when volatility drops.
- Contract term: The options curve is steepest over the first 60 days, so we typically write one- or two-month contracts to take advantage of the near months when the market is most volatile. Writing shorter-term options also provides greater flexibility — contracts expire worthless in the least amount of time, which allows us to write new contracts and adjust the option’s strike price more frequently to capture greater upside.
Using a covered call overlay enhances income and lowers dependence on capital gains for a positive total return.
BMO’s covered call and premium yield strategies
With uncertainty continuing to be a significant story in markets, BMO’s suite of covered call and premium yield products is situated to monetize volatility while generating significant income. Please note that yields listed below are net of fees, and as of October 19, 2022.
BMO Covered Call Canadian Banks ETF (Ticker: ZWB)
Banks have sold off as of late, presenting an attractive valuation opportunity. Their fundamentals continue to be strong, with forward price-to-earnings below 10x, and underlying dividend yield in excess of 4%.2
Canadian dividend equities continue to benefit from a factor shift from Growth to Value, with Energy, Materials and Utilities benefiting in particular. Features exposure to companies with solid historical dividend growth, as well as additional income through covered calls.
BMO Covered Call Utilities ETF (Ticker: ZWU)
Utilities and Energy pipeline equities have been in recent demand. The current volatile geo-political environment lends itself well to the generation of high income from option premiums.
BMO Premium Yield ETF (Ticker: ZPAY)
ZPAY uses option strategies (put-write and covered calls) combined with some long stock exposure to provide enhanced income with less volatility, more diversification, higher yield and partial market exposure. It is also available in U.S dollar units (ZPAY.U) and hedged to Canadian dollar units (ZPAY.F).
* Annualized distribution yield, net of management fees, as of October 19, 2022.
Exhibit #3: Product and performance details for BMO’s complete covered call and premium yield suite (as of September 30, 2022)
|ETF / Mutual Funds||% Covered||% Out-of-|
|1st Month||2nd Month||3rd Month||Annualized|
|% Covered||% Out-of-|
|1st Month||2nd Month||3rd Month||Annualized|
Data as of September 30, 2022. Source: BMO Asset Management Inc. *3 month trailing average.
For additional insights, see BMO’s monthly Covered Calls, Derivatives, and Volatility Landscape report.
Please contact your BMO ETF Specialist for more information. Our Portfolio Managers are also available to help with trading insights. They can also be reached at 1−877−741−7263.
1 As compared to an investment that generates an equivalent amount of interest income.
2 Annualized Distribution Yield: The most recent regular distribution, or expected distribution, (excluding additional year end distributions) annualized for frequency, divided by current NAV.
Any statement that necessarily depends on future events may be a forward-looking statement. Forward-looking statements are not guarantees of performance. They involve risks, uncertainties and assumptions. Although such statements are based on assumptions that are believed to be reasonable, there can be no assurance that actual results will not differ materially from expectations. Investors are cautioned not to rely unduly on any forward-looking statements. In connection with any forward-looking statements, investors should carefully consider the areas of risk described in the most recent simplified prospectus.
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