How to use covered call strategies?

Key Concepts

• Covered Call Strategy: An options strategy where an investor holds a long position in an asset and sells (writes) call options on that same asset to generate income (premiums).
• Volatility (VIX): A measure of market expectation of near-term volatility. High volatility increases the premiums received from selling options.
• Dividend Champions: Stocks with a long-term track record (e.g., 25+ years) of consistent dividend growth, often used as a defensive strategy during market turbulence.
• Return of Capital (ROC): A distribution from an investment that is not considered taxable income but rather a return of the investor's original investment.
• Yield Maximization: An investment philosophy focused on generating high income through active management and options writing.

1. Tactical Portfolio Management in Volatile Markets

Nick Piccard, Chief Option Strategist at Hamilton ETFs, emphasizes that while radical portfolio changes are discouraged during geopolitical instability (such as the situation in the Strait of Hormuz), investors can employ tactical strategies to monetize market volatility.

• Monetizing Volatility: When market uncertainty drives the VIX higher, option premiums become more expensive. By selling call options on existing holdings, investors can capture this "volatility premium" as income.
• The "Win-Win" Scenario: In the current energy sector, investors are benefiting from both rising underlying asset prices and increased volatility, which allows for higher income generation through covered calls compared to stable, low-volatility environments.

2. Covered Call Strategy: Mechanics and Application

The strategy involves selling call options to investors who are bullish on the stock's upside.

• Example (Suncor): Piccard notes that on an $89 stock, selling a one-month call option could generate approximately $3 in premium. This represents a potential monthly yield of nearly 3%.
• Trade-off: The primary cost of this strategy is the capping of upside potential. If the stock price rises significantly above the strike price, the investor does not participate in those gains beyond the strike price.
• Performance Comparison: Piccard highlights the EMAX (Energy Covered Call ETF). While the broader TSX Energy Index returned 73% over the past year, EMAX returned 59%. The strategy intentionally sacrifices some capital appreciation for consistent, higher income distributions.

3. Defensive Investing: The "Dividend Champions" Approach

For investors seeking to mitigate risk during market swings, Piccard advocates for a "quality" approach focused on companies with long-term dividend growth.

• Strategy: Focus on companies that have grown their dividends for over 25 years, such as Enbridge or Royal Bank.
• Diversification: The Canadian Dividend Champions (C-MVP) strategy includes a mix of banks, pipelines, and consumer staples. This diversification is designed to outperform broad benchmarks like the TSX 60 while maintaining lower volatility for the investor.
• Performance: The C-MVP strategy yielded a 42% total return over the past year, providing a defensive buffer compared to more volatile, concentrated indices.

4. Tax Efficiency and Distributions

A significant consideration for income-focused ETFs is the nature of the distributions paid to shareholders:

• Option Premiums: These are generally treated as capital gains, which can be tax-efficient.
• Return of Capital (ROC): Because covered call strategies may not capture the full upside of a rallying stock, some distributions are classified as return of capital. Piccard notes that, overall, these products are structured to be tax-efficient for the end investor.

Synthesis and Conclusion

The core takeaway is that in a volatile market, investors do not need to abandon their positions. Instead, they can pivot toward income-generating strategies that leverage high volatility to produce cash flow. While covered call strategies (like EMAX) and dividend-growth strategies (like C-MVP) may lag behind the absolute peak performance of a bull market, they offer a disciplined, lower-volatility path to total return that prioritizes consistent income and capital preservation. Investors must be willing to trade off "uncapped upside" for the certainty of regular distributions.