An Alternative ETF Strategy for Heightened Volatility

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The recent equity market correction shows that the aging bull market rally is susceptible to sudden bouts of extreme volatility, and with a rising rate environment and surprise moves out of the Trump administration, investors may expect more oscillations ahead.

Consequently, investors who are wary of the potential risks may turn exchange traded funds that track buy-write or covered call strategies to generate attractive yields if markets slowdown in the year ahead.

"Covered call strategies can potentially benefit an investor during periods of heightened volatility," Garrett Paolella, Managing Director at Horizons ETFs US, said in a note.

Covered-call options allow an investor to hold a long position in an asset while simultaneously writing, or selling, call options on the same asset. Traders would typically employ a covered-call strategy when they have a neutral view of the markets over the short-term and just gather income from the option premium. While these buy-write ETFs may not produce any phenomenal price returns compared to the broader equities markets, their underlying option strategy helped them generate outsized yields.

During volatile conditions, the level of premium that can be generated on call writing also typically increase. This additional premium could diminish the volatility of the investment compared to non-covered call strategies. The options premium helps serve as both a buffer and a measure of downside protection during market sell-offs.

If the markets stay within range or trade in a more sideways fashion, investors would use the covered call strategy to generate a premium on the option. If shares fall, the option expires worthless and one still keeps the premiums on the options. However, potential investors should keep in mind that the strategy can cap the upside of a continued rally. The trader keeps the premium generated but any gains beyond the strike price will not be realized. Consequently, in a stock market rally, the covered call strategy has underperformed the equities market.

For example, an investor can look to something like the Horizons Nasdaq 100 Covered Call ETF (NasdaqGM: QYLD) to capture a covered-call strategy that targets Nasdaq-100 securities. QYLD has a 0.60% expense ratio and generated a 8.18% 12-month yield. The ETF is up 4.8% year-to-date and 18.7% higher over the past year, compared to the Nasdaq Composite's 7.8% gain so far this year and 28.6% rise in the past year.

"Covered call ETFs seek to create an alternative and/or complement to your current income investments," Paolella said. These types of funds "are designed to offer investors with potential monthly income while seeking to lower the risk profiles of a variety of major U.S. indexes."

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