As covered call option ETFs grab more market share, should advisors consider puts?

Last year, covered call ETFs attracted $9.8 billion in flows, eight per cent of total net inflows in the same year and 16 per cent of net equity ETF inflows, according to TD Securities. It was a landmark year that saw a few ETF issuers win big on their options strategies. Covered call option ETFs hold a basket of securities, usually equities, and sell covered calls, the option to buy some of those securities at a certain price, to generate premiums which are passed on to investors as income. While that combination of equity exposure with income, at the cost of lower upside potential, has been attractive to many Canadians, there’s another side to the options market with far less retail product: puts. 

Chris Thom, Portfolio Manager at Moat Financial Limited in Vancouver, believes that the education gap around put options has meant that investors and advisors aren’t as familiar with these options strategies. He outlined how puts work and how he and his team use puts to build income strategies. He outlined the risk metrics and tradeoffs inherent in this options market and emphasized the utility of a puts strategy for clients who want income but don’t want risk.

“Covered calls have really caught on because they’re very simple. Long stocks is something people have been doing for hundreds of years. With a covered call, you’re just long a stock and then you sell that option on that,” Thom says. “The put is a bit different. You have cash that’s sitting there waiting and then you sell a put on a stock that you don’t own. You have nothing to do with. You’re just basically telling the market, I will buy this stock at that price by selling the put. It’s sort of like a bit of a two part thing. It’s not complicated, but it’s just complicated enough.”

Simplifying put options in an ETF

In the case of a put options ETF like the one offered by Moat, through Longpoint ETFs, the portfolio is largely in a money market fund, generating interest. The management team is selling puts on stocks with liquid options markets that they believe should appreciate. The put contract means that the ETF will buy a stock that it’s sold a put on if it falls below a certain price. If that stock stays flat, rises, or even falls to a point above that set price, then the ETF will continue to hold cash and generate premiums and interest. If the price falls to the level of the put, then the ETF buys that stock.

While those purchases at low prices can seem positive in the age of v-shaped recoveries, Thom acknowledges that the risk is typically to the downside. He notes, though, that through premiums accrued the risk is typically lower than simply owning the stock, or owning the stock with a call option as that strategy would see the ETF participate in the full move to the downside. Once the stock is acquired, Thom says his team might go long on that equity if they believe in it. He says, though, that they are more likely to sell calls on the equity, which should eventually result in its sale, or sell the position outright.

Unlike a growing cohort of covered call ETFs, Thom says that put ETFs like his won’t use leverage to generate more options sales. Instead, the fund maintains a cash position large enough to buy all their put contracts if the market moves down significantly. In the meantime, the ETF is meant to deliver ‘base hits’ while offering better protection against the downside

Why puts now?

Two aspects of the contemporary market environment make puts more attractive in Thom’s view. The first is that interest rates have normalized and managers like him can now get solid interest income on the cash positions they need to maintain for a put strategy. The second, he says, is that US and Canadian equity markets are at all time highs. If a correction is coming, which has been a source of much debate through this year, then a put strategy can offer some protection against the downside and a chance to “get paid to wait.”

A put strategy, unlike a call option ETF, doesn’t rely on markets moving higher to generate its returns. Thom explains that if an investor or advisor believes the market can’t move higher from here, but still has income and total returns needs, then a strategy like that can help.

On a technical level, market efficiency means that options premiums are usually equivalent between calls and puts. Costs, too, are arguably better managed than a call option ETF with leverage, where total cost reporting requirements will see interest costs for that leverage broken out in client statements. Cash positions are typically cheap to maintain from a fee standpoint, and the commission for an options contract is typically $1 per contract. While call options can be traded inside registered accounts, Thom says that put options cannot. However, a put option ETF can be held in a registered account. Beyond a clear understanding of the technical details, Thom says that advisors need to be prepared to educate themselves and their clients on the fundamentals of put options.

“This is not riskier than owning stocks outright. This is not riskier than covered calls, which [clients] may or may not be familiar with,” Thom says. “In fact, it is a lower risk strategy because you are giving yourself exposure at lower prices and embedding downside protection into every trade.”