“A bird in the hand is worth two in the bush” is a phrase you’ll probably hear when a money manager explains their call option writing strategy.
The process requires expertise, can get complex and is not for the easily confused individual investor. Paul MacDonald, CIO and portfolio manager at Harvest Portfolios Group, took time out from overseeing his firm’s in-depth analytical process to break down the benefits of options for WP and explain why it is such an effective income generator.
His strategy feeds into the Oakville, Ontario-based firm’s one-line mantra: “Unique, quality large cap investment solutions that follow an active proven process, are simple to understand and generate attractive equity income.”
Making it easy for the average investor to understand is vital but, of course, it ultimately comes down to returns and MacDonald said the number one reason for covered calls is to generate tax advantaged income, with slightly lower volatility a secondary benefit.
“Covered calls are really designed for investors that are looking for enhanced income from their equity investments,” he said. “Typically, people that like dividends want high dividends and this is an alternative way to get more income out of your equities.”
So how does it work? MacDonald picked up the baton. “Assume that I own a stock that’s priced at $50,” he said. “I can sell a call option – known as writing – at $50 and I will get $2 in premium. So whether that stock goes up or down, I get to keep that $2.
“The trade-off is if I sell a call option on my entire position and stock goes to $47, I’m $2 better off because that’s a bird in hand, so to speak. But if the stock goes from $50 to $55, I only have my two dollars so you forego the upside on the written position of your securities.”
However, you don’t have to write on the entire amount and Harvest writes up to a maximum of 33%. Following the above example, therefore, it would write on a third of its holdings, so if the market went up it to $55 it would earn $2 on 33% but still capture about 66% of that upside.
Covered calls are also taxed as capital gains, which means its tax efficient, and MacDonald said the strategy is a consistent method. He added, though, that market-timers may feel it’s a good way to tackle late cycle with lower volatility while maintaining upside. Harvest welcomes volatility as it increases the premium.
MacDonald said: “We know we are not at the beginning of the cycle so now might not be a bad time to forego a little bit of the upside in place of a healthy distribution. The other part of this is the way options are priced; that $2 is not a set $2 every month – there is a number of variables that go into it but one of them is actually volatility. When volatility goes up, we actually get paid more on our premiums, so we like it when the markets are volatile because we get more premium and it allows us to be more active on the strategy as well.”
Harvest has four components to its strategy designed to keep it flexible and active. They are:
Flexible write mandate: Harvest may choose to write on all names, a select few or none if market conditions warrant, which is rarely expected to be the case. Not all equities move in unison and at times specific news related to an announcement can move an equity’s price.
Flexible write level: Harvest can write up to 33% on any individual equity in the fund. This flexibility gives the portfolio manager the ability to judge the current volatility of the individual equities in the portfolio.
Flexible multiple strike levels: the firm can write several options on an individual equity at different strike prices through the month. This is usually implemented when an equity is experiencing strong short-term upward price movement providing higher premium income and an opportunity for the fund to capitalize on a short term pull back on the price of the equity.
Flexible timing: Harvest is not required to enter into new option positions immediately following the latest expiry. Instead, the strategy allows positions to be entered into, in whole or in part, at any time during the expiry period. In conjunction with the use of multiple strike levels this allows for a tactical approach to maximizing capital appreciation while receiving option premiums.
These pointers provide a glimpse into the Harvest operation and MacDonald said it’s an area where investors really benefit from expertise and economy of scale.
He said: “We have all kinds of propriety analytics that we look at to try to determine what position options to write on and what percentage levels and, ultimately, why we are getting paid the premium we are for each position.
“I think in an environment where we have very choppy markets, you really want to have an experienced hand doing your options strategy.”
He added: “We do have an active component to equity selection and we have seasoned portfolio managers doing that, and part two is the option overlay that is very active on a month-over-month basis.”
Call options strategies are available on the following Harvest ETFs: Harvest Tech Achievers Growth & Income ETF; Harvest Energy Leaders Plus Income ETF; Harvest Brand Leaders Plus Income; Harvest Healthcare Leaders Income ETF; Harvest European Leaders Income ETF; Harvest US Bank Leaders Income ETF; Harvest Global Resource Leaders ETF and Harvest Global REIT Leaders Income ETF.