Investors Who Want Income Should Understand This Sloppy Stock Market Strategy

There is a way to increase that income while reducing your risk.

Below is a description of an income strategy for stocks you might not be aware of – covered call options – as well as examples from Kevin Simpson, the founder of Capital Wealth Planning at Naples, Florida, which manages the Amplify CWP Enhanced Dividend Income ETF. DIVO,
+ 0.19%.

This exchange-traded fund is rated five stars (highest) by Morningstar. We’ll also look at other ETFs that use covered calls in a different way, but with income as the primary focus.

Covered purchase options

A call option is a contract that allows an investor to buy a security at a particular price (called an exercise price) until the option expires. A put option is the opposite, allowing the buyer to sell a security at a specified price until the option expires.

A covered The option to buy is an option that you write down when you already own a title. The strategy is used by equity investors to increase income and provide some downside protection.

Here is a current example of a covered call option in the DIVO portfolio, described by Simpson in an interview.

On August 23, the ETF wrote a month-long appeal for the ConocoPhillips COP,
+ 2.64%.
At that time, the stock was trading at around $ 55 a share. The call has an exercise price of $ 57.50.

“We collected between 70 cents and 75 cents per share” on this option, Simpson said. So if we go down, 70 cents a share, we have a return of 1.27% for just one month. This is not an annualized number – it shows how much income can be made from the covered buy strategy if used over and over again.

If the shares of ConocoPhillips go above $ 57.50, they will likely be called – Simpson and DIVO will be forced to sell the shares at that price. If this happens, they may regret parting with a stock they love. But with the 70 cents per share for the option, they will also have benefited from a 4.6% gain over the share price when they purchased the option. And if the option expires without being exercised, they are free to write another option and earn more income.

Meanwhile, ConocoPhillips has a dividend yield of over 3%, which in itself is attractive compared to Treasury yields.

There is still a risk. If ConocoPhillips doubled to $ 110 before the option expired, DIVO would still have to sell it for $ 57.50. All that advantage would be left on the table. This is the price you pay for the income provided by this strategy.

Simpson also provided two previous examples of actions he wrote covered calls for:

• DIVO bought shares of Nike Inc. DE,
  -2.88%
  for between $ 87 and $ 88 per share in May 2020 after the stock was withdrawn, then recorded $ 4.50 per share in income by writing repeated covered call options for the stock through December. Simpson finally sold the stock in August after reserving an additional $ 5 per share in option premiums.

• DIVO earned $ 6.30 per share in covered purchase premiums on shares of Caterpillar Inc. CAT,
  -0.22%,
  who were recalled “in late February for between $ 215 and $ 220,” Simpson said. After that, the stock climbed to $ 245 in June, showing a rising loss. Caterpillar’s stock has now returned to around $ 206.

Simpson’s strategy for DIVO is to hold a portfolio of around 25-30 blue chip stocks (all of which pay dividends) and write only a small number of options at any one time, depending on market conditions. Marlet. This is primarily a long-term growth strategy, with improved income from covered call options.

The fund currently has five covered long positions, including ConocoPhillips. DIVO’s primary focus is growth, but it has a monthly payout that includes dividends, option income, and sometimes return of capital. The 30-day SEC quoted yield of the fund is only 1.43%, but this only includes the dividend portion of the distribution. The return on the distribution, which is what investors actually receive, is 5.03%.

You can see the main holdings of the fund here on the MarketWatch quote page. Here’s a new guide to the quote page, which includes a wealth of information.

DIVO’s performance

Morningstar’s five-star rating for DIVO is based on the performance of the ETF within the investment research firm’s US Fund Derivative Income peer group. A comparison of the ETF’s total return with that of the S&P 500 SPX index,
-0.09%
It can be expected to underperform over the long term, consistent with the focus on income and giving up some upside potential for stocks that are called under the covered buying strategy.

DIVO was launched on December 14, 2016. Here is a comparison of returns based on net asset value (with dividends reinvested, although the fund might be best for investors who need income) for the fund and its Morningstar category , as well as the returns for the S&P 500 calculated by FactSet:

	Total return – 2021	Total return – 2020	Average yield – 3 years
Amplify CWP Enhanced Dividend Income ETF DIVO, + 0.19%	13.8%	13.2%	13.9%
Morningstar U.S. Fund Derivative Income Class	13.0%	4.3%	8.3%
S&P 500 SPX, -0.09%	19.9%	18.4%	17.8%
Sources: Morningstar, FactSet

Repayment of capital

Return of capital may be included as part of a distribution by an ETF, closed-end fund, real estate investment trust, business development company or other investment vehicle. This distribution is not taxed because it is already the investor’s money. A fund may return certain capital to temporarily maintain a dividend, or it may return capital instead of making some other type of taxable distribution.

In a previous interview, Christian Magoon, CEO of Amplify ETFs, distinguished between “accretive and destructive” returns on capital. Accretive means that the fund’s net asset value (the sum of its assets divided by the number of shares) continues to increase, despite a return of capital, while destructive means that the net asset value falls, which is a bad investment in time if it continues.

Calls covered on entire indexes

There are ETFs that take the covered call strategy to the extreme, selling options against an entire stock index. An example is the Global X Nasdaq 100 Covered Call ETF QYLD,
-0.01%,
who owns the shares that make up the Nasdaq-100 NDX index,
-0.33%,
in the same proportions as the index, while continuously selling covered call options on the entire index. QYLD has a four star rating from Morningstar.

The ETF pays monthly; its 12-month rolling distribution yield has been 12.47% and its distribution yields have consistently been above 11% since its inception in December 2013.

It’s a bit of an income. However, QYLD also stresses the importance of understanding that a “pure” covered buy strategy across an entire stock index is actually an income strategy.

Here is a comparison of the returns of the Invesco QQQ QQQ Fund and Trust,
-0.39%,
which tracks the Nasdaq-100, from late 2019, encompassing the entire COVID-19 pandemic and its effects on the stock market:

QYLD dipped sharply in February 2020, as did QQQ. But you can see that QQQ recovered faster and then soared. QYLD continued to pay its high distributions throughout the pandemic crisis, but it failed to capture most of QQQ’s additional benefits. It is not designed to do this.

Global X has two other funds following covered buy strategies for entire income indices:

• The Global X S&P 500 XYLD Covered Call ETF,
  + 0.22%

• The Global X Russell 2000 RYLD Covered Call ETF,
  + 0.17%

Covered buy strategies can work particularly well for stocks that have attractive dividend yields, and some investment advisers use the strategy for individual investors. ETFs offer an easier way to follow strategy. DIVO uses covered calls for a growth and income strategy, while the three listed Global X funds are more income oriented.

Don’t miss: Here is a safer way to invest in bitcoin and blockchain technology