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Deep Dive: Buyers who need revenue want to know this missed inventory market technique

Interest rates remained low even after the pandemic.

The yield on 10-year US Treasuries
TMUBMUSD10Y,
1,371%
not more than 2% for more than two years. (The return is 1.32% on Monday.)

As a result, many income-oriented investors have migrated to the stock market from what are considered to be the safest income investments in bonds. But the returns from a diversified stock portfolio may not be high enough.

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

Below is a description of an income strategy for stocks you may not be familiar with – covered call options – along with examples from Kevin Simpson, founder of Capital Wealth Planning in Naples, Florida who manages the Amplify CWP Enhanced Dividend Income ETF
DIVO,
-0.78%.

This exchange traded fund is rated five stars (the highest) by Morningstar. We'll also look at other ETFs that use covered call options in other ways, but with the primary goal of income.

Covered call options

A call option is a contract that enables an investor to buy a security at a certain price (known as the exercise price) until the option expires. A put option is the opposite in which the buyer can sell a security at a certain price until the option expires.

A covered call option is an option that you write when you already own a security. The strategy is used by stock investors to increase returns and provide some protection against losses.

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 call for ConocoPhillips
POLICE OFFICER,
-0.52%.
At the time, the stock was trading at about $ 55 per share. The call has a strike price of USD 57.50.

"We raised between 70 cents and 75 cents a share," said Simpson. So if we go on the low side, 70 cents a share, we have a 1.27% return for just one month. This is not an annualized number – it shows how much income the covered call strategy can generate if used over and over again.

If ConocoPhillips' shares rise above $ 57.50, they will likely be recalled – Simpson and DIVO will be forced to sell the shares at that price. When that happens, they may regret parting with a stock they like. But along with the 70 cents per share for the option, they will also have enjoyed a 4.6% gain over the share price at the time the option was issued. And if the option expires without exercising, they are free to write another option and earn more income.

Meanwhile, ConocoPhillips has a dividend yield of more than 3%, which is attractive even when compared to government bond yields.

Still, there is a risk. Should ConocoPhillips double to $ 110 before the option expires, DIVO would still have to sell it for $ 57.50. All of these benefits would remain on the table. That's the price you pay for the income this strategy offers.

Simpson also provided two previous examples of stocks he wrote covered calls on:

DIVO bought shares of Nike Inc.
NKE,
-0.75%
for between $ 87 and $ 88 per share in May 2020 following the stock's withdrawal, and then posted $ 4.50 per share of revenue by repeatedly writing covered call options on the stock through December. Simpson finally sold the stock in August after posting an additional $ 5 per share in option bonuses.

DIVO earned $ 6.30 per share in covered call awards on shares of Caterpillar Inc.
CAT,
-1.89%,
which were "withdrawn at $ 215-220 at the end of February," Simpson said. After that, the stock rebounded to $ 245 in June, showing some loss of upside potential. Caterpillar stock has now dropped to about $ 206.

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

The fund currently has five covered call positions, including ConocoPhillips. DIVO's main goal is growth, but it has a monthly payout that includes dividends, option income, and sometimes a principal return. The fund's 30-day listed SEC yield is only 1.43%, but that only includes the dividend portion of the distribution. The distribution yield that investors actually receive is 5.03%.

You can see the fund's top positions here on the MarketWatch price page. Here's a new landing page guide that has a wealth of information in it.

DIVO's performance

Morningstar's five-star rating for DIVO is based on the performance of the ETF within the “U.S. Fund Derivative Income ”peer group. A comparison of the total return of the ETF with that of the S&P 500 index
SPX,
-0.91%
In the long term, a lower performance is to be expected, which corresponds to the earnings orientation and the abandonment of a certain upside potential for stocks that are called as part of the covered call strategy.

DIVO was founded on December 14, 2016. Here's a comparison of the NAV-based returns (with dividends reinvested, although the fund may be best for investors in need of income) for the fund and its Morningstar category, along with the returns for the S&P 500 calculated by FactSet :

Total Return – 2021

Total Return – 2020

Average return – 3 years

Amplify CWP Enhanced Dividend Income ETF
DIVO,
-0.78%

13.8%

13.2%

13.9%

Morningstar U.S. Fund derivative income category

13.0%

4.3%

8.3%

S&P 500
SPX,
-0.91%

19.9%

18.4%

17.8%

Sources: Morningstar, FactSet

Return of capital

A return on investment can be considered as part of a distribution by an ETF, closed-end fund, real estate fund, business development company, or other investment vehicle. This distribution is not taxed as it is already the investor's money. A Fund may return some of the capital to hold a dividend temporarily, or it may return capital in lieu of making some other type of taxable distribution.

In a previous interview, Amplify ETFs CEO Christian Magoon made a distinction between “increasing 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 rise despite the return of capital, while destructive means that the net asset value falls, which over time will result in a poor investment if it persists.

Covered calls for whole indexes

There are ETFs that take the covered call option strategy to extremes by writing options against an entire stock index. One example is the Global X Nasdaq 100 Covered Call ETF
QYLD,
-1.13%,
which contains the stocks that make up the Nasdaq 100 index
NDX,
-1.18%,
in the same proportion as the index, while covered call options are continuously written against the entire index. QYLD has a four-star rating from Morningstar.

The ETF pays monthly; The distribution yield for the last 12 months was 12.47% and the distribution yield has been consistently above 11% since it was founded in December 2013.

That's quite a lot of income. However, QYLD also underscores the importance of understanding that a “pure” covered call strategy on an entire stock index is really a profit strategy.

Here is a comparison of the returns on the fund and the Invesco QQQ Trust
QQQ,
-1.18%,
which will track the Nasdaq-100 as of late 2019 and encompass the entire COVID-19 pandemic and its impact on the stock market:

Fact set

QYLD suffered a major slump in February 2020, as did QQQ. But you can see that QQQ recovered faster and then skyrocketed. QYLD continued to pay its high payouts throughout the pandemic crisis but failed to capture most of QQQ's additional upside potential. It's not designed for that.

Global X has two other funds that have covered call strategies for entire indices for income:

The Global X S&P 500 Covered Call ETF
XYLD,
-0.78%

The Global X Russell 2000 Covered Call ETF
RYLD,
-0.04%

Covered call strategies can work especially well for stocks with attractive dividend yields, and some investment advisers use the retail investor strategy. The ETFs provide an easier way to follow the strategy. DIVO uses covered calls for a growth and earnings strategy, while the three Global X funds listed are more income-oriented.

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