Performance ETFs: Using Options for Higher Dividend Yields

24/7 Wall St. Perspectives

• Options provide exponential leverage for trading the markets, but carry commensurate risk.
• “Outcome” ETFs are an entire subcategory of ETFs that use different types of options strategies that have emerged over the past few years.
• While Outcome ETFs’ returns can be in the double digits in the right conditions of market volatility, management fees are also commensurately higher.
• Dividends are the purist form of passive income, which is why we bring the best dividend-paying stocks to 24/7 Wall Street readers. Just click here for a free report on two high dividend stocks.

In the movie Wall Streetcorporate raider Gordon Gekko (Michael Douglas) commits insider trading based on information from young stockbroker Bud Fox (Charlie Sheen), placing the following order: “Buy 1500 July 50 calls. Start buying 1000 blocks of shares and take them up to $50. When it reaches 50, give your friends a little taste. Then call the Wall Street Journal and tell them the Blue Horseshoe loves Anacott Steel.”

The order placed by Gekko is for call options. Each option is equal to 100 shares, so in this case the option part of the order is equivalent to 150,000 shares. Since the strike price is below $50, the options are what’s called “in the money,” so they’re probably only worth $250 each. So maybe $375,000 in total, versus if the price was $45, which would be $6.75 million.

Options: More than trading speculation

Veteran traders and fund managers use options for a variety of applications beyond leveraged speculation trading.

Options and futures are an area of ​​the capital markets that exponentially increases the upside potential of a trade, but also increases the risk proportionately. The entire value of the option can become worthless if its strike price is above the price of the underlying stock for calls or below it for puts by the expiration date (usually the third Friday of the designated month).

However, options have a number of other uses besides leveraged trading speculation. Much literature has been written by option strategists using options for hedging, income growth, and other fund management tactics. These techniques are often applied in commodity futures, foreign exchange, interest rate swaps and ETFs.

Options Strategies with ETFs

The use of options strategies to improve ETF performance has exploded in recent years, with 67 Outcome ETFs launched in 2023.

Exchange-traded funds (ETFs) have been covered countless times in various capacities in previous Wall Street 24/7 articles. Like mutual funds, they are usually designed to be representative of specific indices that track different groupings in the capital markets. For investors looking to allocate funds to ride the returns of a particular index, the ETF is the preferred vehicle of choice.

Innovative fund managers have developed a number of options-related strategies that have become useful tools to better achieve certain management objectives in the ETF arena. These ETFs emerged and grew into a subcategory that was called “Outcome” ETFs. As an example of their rate of expansion, 67 new Outcome ETFs were launched in 2023 alone. Some Outcome ETFs have begun to focus on specific groups of non-indexed stocks in the technology sector, such as AI, or even certain actions such as AMD.

In recent years, five general strategies have emerged from Outcome or Buffer ETFs:

Increase covered call revenue

Covered call option strategies have become a popular tool for exponentially growing ETF returns.

This strategy is by far the most popular and widespread among Outcome ETFs. The fund engages in a monthly practice of eliminating out-of-the-money calls that expire worthless most of the time. The premium collected from the options increases the ETF’s monthly dividend yield above the gain achieved by tracking the underlying index. The Fund risks having to redeem the options if the index unexpectedly exceeds the strike price to become at or in the money before the expiration date. The Fund may also use put options in bullish strategies. For volatile Magnificent 7 stocks like Nvidia, dedicated ETFs that use options strategies but are cheaper per share than even Nvidia’s post-split price often generate superior monthly returns due to aggressive options strategies.

Some popular examples of higher income focused outcome ETFs include:

• S&P 500 Enhanced Options Income ETF (NYSE: JEPY )

• Global X NASDAQ 100 Covered Call ETF (NASDAQ: QYLD)
• YieldMax AI Option Income Strategy ETF (NYSE: AIYY)

ETFs with tail risk

Tail Risk ETFs use options as a strategy to reduce downside risk against a market selloff.

These ETFs essentially track the underlying index but maintain hedging positions. These take the form of deep out of the money puts as protection against a sudden market sell-off or crash, as seen recently with the early August market sell-off.

Some examples would be ETF Global X S&P 500 Tail Risk (NYSE: XTR) and Pro Shares VIX Short Term Futures ETF (CBOE: VIXY).

Collar ETFs

Collar ETFs can implement option spread strategies involving both call and put options.

To meet the demands of reduced market volatility, Stocks combined with put-spread collars have become a popular method of creating more conservative investments with lower volatility. Collar ETFs were named for implementing a collar ladder that expires over 3 consecutive months, attempting to create a hedged stock experience. Put spreads usually involve two different put strike prices or being long a put while selling a call option.

An example of a Collar ETF would be Simplify Hedged Equity ETF (NYSE: HEQT).

Risk Managed Income ETFs

Risk-managed ETFs create an arbitrage scenario, making a profit by selling a call for more money than the cost of a put, while reducing the fund’s volatility.

In another use of option spread strategies, a risk-managed income ETF acquires out-of-the-money puts and sells calls. The ETF earns the difference between the premium from selling the calls and the cost of buying the puts. An example of a risk-managed income ETF would be Global X NASDAQ 100 Risk Managed Income ETF (NASDAQ: QRMI ).

Buffer ETFs

Buffer ETFs implement options over a 12-month cycle that combine 9-20% mitigation of downside risk while relying on any upward appreciation in an index.

A hybrid variant of enhanced income and risk-managed income ETFs is the buffer ETF. Based on a defined 12-month timeframe, buffer ETFs add a risk reduction component to their options strategy to better address investor concerns and by implementing options to protect against a fixed percentage of downside. A different ETF is offered at the start of each month with a risk reduction of between 9-20% over index sales.

For example, PGIM offers a series of 12% buffer ETFs, the PGIM US Large Cap Buffer 12 August ETF (CBOE: AUGP)and the 20% PGIM US Large Cap Buffer 20 August ETF (CBOE: PBAU).

BlackRock’s asset management leviathan offers three different buffer ETFs:

• iShares Large Cap Max Buffer Jun ETF (CBOE: MAXJ)

• iShares Large Cap Deep Buffer ETF (CBOE: IVVB)
• iShares Large Cap Moderate Buffer ETF (CBOE: IVVM)

All 3 are new and dated July 31, 2024.

Pros and cons

Performance ETFs are capable of substantially higher returns, while their fees are exponentially profitable for their managers.

Depending on how aggressive the resulting ETF is, some of the returns can amount to impressive double-digit returns, some even in the 20-30% range. These figures can be generated provided the market volatility is sufficient to warrant the higher premiums from selling the calls.

Conversely, management fees for such high-pressure activity and monitoring are also proportionately higher, with some fees four times those of passive ETFs.

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