How a covered call spread gold ETF works

Gold bullion might not be the first asset that comes to mind when we think about options strategies. Gold is a textbook safe haven asset that has enjoyed a rapid price appreciation run in recent years. Technical limitations of options liquidity, physical storage, and portfolio utility come to mind when considering the idea of a covered call option overlay on the yellow metal. BMO GAM, however, seems to have cut through all that. A new ETF from the issuer, trading under the ticker ZWGD, applies a covered call spread strategy to generate a roughly five per cent target annualized yield on an ETF that retains exposure to the price of gold.   

Bipan Rai, managing director, head of ETFs and alternatives strategy at BMO GAM explained exactly how this new ETF works. He outlined the novelty of a covered call spread strategy which is meant to balance the upside trade-offs inherent in covered call options. He highlighted the relative uniqueness of this approach and explained how advisors might want to consider using it now.

“We’ve taken our existing gold bullion ETF and added yield to it with quite a different approach from the traditional covered call strategy,” Rai explains. “This is a covered call spread where we are writing calls at a lower out of the money strike price and buying a long position at a higher strike price out of the money. This is replicating a bear call spread strategy which generates yield while missing the move on the near leg, while allowing you to participate in gold when it moves further out of the money.”

Rai says that this approach addresses a common investor critique of gold: that it doesn’t generate any yield when it sits in portfolios. By writing calls on an ETF, rather than trying to sell options on physical gold, they also have sought to address possible liquidity issues. Rai notes that the underlying gold billion ETF, ZGLD, holds just under $1 billion in assets, implying a level of scale required for options trading on an ETF.

The approach has a clear trade-off. The ETF won’t fully participate in price moves below the initial strike price. In exchange, however, the ETF harvests yield. Moreover, Rai explains that write levels on that initial covered call strategy will cover only around 50 per cent of the underlying portfolio, meaning the other 50 per cent ends up retaining exposure to gold. Moreover, because of the spread aspect to the strategy, when gold moves beyond a certain point the ETF starts participating in upward movement again. It’s another layer meant to ensure that muted growth is not as acutely felt during a positive run up in gold.

One of the defining features of options strategies is their price correlation with volatility. When implied volatility on an asset is higher, options premiums are higher. While volatility advantages might not be immediately thought of in relation to the textbook safe haven asset, Rai notes that implied volatility on gold tends to rise when gold prices rise. The positive trend we have seen in gold over recent years has actually added to its implied volatility and made an options strategy more attractive.

While that price appreciation in gold has been a welcome source of return for investors, Rai notes that this ETF is designed to complement gold’s traditional role as a diversifier and a stabilizer. The critique levied against that use, he notes, is that the gold pays no yield while it sits in the portfolio. This strategy, he says, addresses that. He notes, too, that the extended gold rally has some investors nervous about a pullback. Shifting to a more muted growth exposure with yield, Rai says, could benefit investors who are more bearish about gold right now.

“You get all the diversification properties of gold, but with the added kicker that you do get some yield as well,” Rai says. “If you want to hold an allocation to gold for an extended period of time there will be periods where gold consolidates rather than appreciates. This is a product that really addresses that concern.”