By Ambrose O’Callaghan
Harvest ETFs is a market leader in ETFs that utilizes option writing strategies. These strategies, include the use of covered calls, a combination of covered calls and cash-secured puts, as wells as covered calls paired with the use of modest to moderate leverage to enhance exposure and income.
Equity Income | The Art of Covered Call Writing
An option is a contract between an option buyer and any option seller that’s entered at a price called the option premium. The option premium is paid to the option seller by the option buyer. The contract grants the option buyer the right and the option seller the obligation, to buy or sell an underlying asset at a predetermined price (the strike or exercise price) on or before a specified date (the expiration or maturity date). By having a right, the option buyer can choose whether to buy/sell or not to buy/sell the underlying asset. The option seller on the other hand must honor the option buyer’s decision (the option seller’s obligation). There are other conditions that option buyer will consider before buying/selling the underlying security on which the option is written. Harvest ETFs has published an in-depth video that details the call option process:
There are several key reasons why Harvest ETFs pursues an option writing strategy:
- Enhances distribution yield over underlying dividend yields
- Creates tax advantaged monthly cash flows from the premium generated by the option writing that is treated as capital gains
- Reduces the ETF’s volatility since the portion of equities that have been written on have the downside protection of the premium collected
- Offers the opportunity to add to total returns in challenging equity market environments
What is a covered call option?
A covered call option is a type of strategy whereby a portfolio manager forgoes a portion of the stock’s upside in exchange for premium income from selling a call option on a stock. Executing a covered call involves two key components:
- Owning the underlying asset
- Selling (writing) call options
Covered calls at expiration: Three outcomes
Scenario A: ABC share price exceeds strike price
The stock price ($105) is higher than the strike price ($100). In this instance, the option buyer will exercise their right to purchase your shares.
Outcome: You are obligated to sell your shares at the $100 strike price. You keep the $3 premium collected upfront.
Final position: You have $103 in cash per share ($100 sale proceeds + $3 premium) and no longer own the stock. You do not participate in any gains above $100.
Scenario B: ABC share price equals strike price
The stock price is equal to the strike price. The option is not exercised by the buyer.
Outcome: You retain ownership of your shares and keep the $3 premium
Final position: You have shares worth $100 plus $3 in cash, for a total value of $103 per share
Scenario C: ABC share price is less than strike price
The stock price ($95) is lower than the strike price ($100). The option expires worthless, and the buyer does not exercise it.
Outcome: You retain ownership of your shares and keep the $3 premium
Final position: You have shares no worth $95 plus $3 in cash, for a total value of $98 per share. The premium received has cushioned the drop in the portfolio’s value
The Harvest covered call strategy
Harvest ETFs is a veteran player in the Canadian ETF market and one of the country’s leading managers of option-writing strategies. Our portfolio management team uses an active and flexible option writing strategy that seeks to generate high levels of monthly cash flow. Meanwhile, positioning the portfolios to capture market growth opportunities.
ETFs the use Leverage
Leverage has carried a mixed reputation among investors. For many clients, the idea of magnified exposure may conjure images of excessive risk. Some may point to products that offer 2x or 3x leverage amplification for every market move. Moreover, these products may contain complex mechanics like daily resets, and the unsettling fear of losing more than the initial investment.
These concerns are real, and they are often compounded by a broader perception that leveraged strategies resemble speculation more than disciplined, long-term investing. When layered onto portfolios built with steady growth and income in mind, it is no surprise that investors have questions.
A growing segment of investment solutions are designed to employing leverage lower levels. The aim is to offer more balanced middle ground: The potential for return enhancement, without taking too much risk long-term investment plan. Even with that in mind, any use of leverage will amplify both the upside and the down of an investment.
Is 25% leverage the “Goldilocks” solution?
Let’s quickly rundown the degrees of leverage available to investors based on their risk tolerance:
20% Leverage: May be too small to meaningfully impact returns
25-33% Leverage: Can have meaningful impact on returns
50% Leverage: Generally regarded as “excessive risk” for most investors
100-200% Leverage (2x-3x): Daily reset issues dominate; Generally, viewed as highly risky for investor with holder period greater than a week, these are typically used by day traders.
Enhanced Income ETFs Explained
Harvest Enhanced Income ETFs apply modest leverage of about 25% to a portfolio that is overlayed with an active covered call option writing strategy.
For example, for every one dollar that is invested in these ETFs, modest leverage is applied by borrowing around $0.25 and adding it to the principal. Because of the leverage component, the Harvest Enhanced ETFs are designed to generate higher levels of income than ETFs that have the same core investments but do not employ leverage. The risk-return profile of Enhanced ETFs is higher than non-levered given the opportunity for higher income and higher growth potential.
Boosting Returns: The “Enhanced” Advantage
Some of the single stock ETFs within the. Harvest High Income Shares lineup employ modest leverage (approximately 25%) to enhance income and growth potential They aim offer amplified exposure and income generation on a specific company’s stock.
Disclaimer
The views and/or opinions expressed above are of a general nature and are for informational purposes only. The contents should not be considered as advice and/or a recommendation to purchase or sell the mentioned securities or used to engage personal investment strategies. Investors should consult their investment advisor before making any investment decision.
Commissions, management fees and expenses all may be associated with investing in Harvest Exchange Traded Funds managed by Harvest Portfolios Group Inc. (the “Funds”). The Funds are not guaranteed, their values change frequently and past performance may not be repeated. Please read the relevant prospectus before investing.
The Funds that use modest leverage of 25% do so to enhance exposure, directly or indirectly, to the underlying stocks. This places them within the category of liquid alternative ETFs. The use of leverage increases the return volatility, meaning it will amplify both gains and losses.
