Are you thinking of adding exposure to the energy sector through a covered call oil and gas ETF? Covered call writing is an investment strategy that has been around for a long time. It is designed to generate income from a stock by selling a call option against it. You are essentially selling the right to buy the stock at a set price in the future.
For example, if you own 1,000 shares of XYZ Company bought at $10 per share, you can write (sell) a call option contract on those 1,000 shares you own at $12 a share (the exercise price). The buyer of this contract will have the option to buy your stocks from you at $12 per share anytime the price is at or above the exercise price for a limited period of time.
If the stock never goes above the exercise price, the option will expire worthless. You would have booked the premium you collected as a profit. The amount really depends on the volatility of the stock, the time of expiration of the option and the difference between the stock price and the exercise price.
The covered call option strategy provides investors with a significantly lower risk level for holding a stock. Income is generated from the written call option premium in addition to the dividend income if it applies (no magic here).
This strategy is best suited to stable markets because in these periods investors collect the option premium without giving up the upside potential of the stock. In a rising market, the upside potential that you sold for a premium can significantly cap your gain. From our example above, the stock held at $10 per share may quickly surpass the exercise price of $12 leaving dwarfing whatever profit you collected from the premium.
In declining markets, it gets worse since the ETF will track the conventional funds it holds. At the same time, selling these covered calls at much lower prices will severely limit the fund’s ability to recover. The upside potential is continuously being sold at lower prices to generate income. These ETFs will not be able to track the market back up when a recovery hits.
In Canada, there are only a few products available that are focused on the energy sector.
HEE Horizons Enhanced Income Energy ETF HEE.TO $12.04 [+0.03]
MER (Management expense ratio): 0.65%
HEE invests in a portfolio of stocks in the Canadian oil and gas sector including both producers and oilfield services companies. HEE provides a 100% exposure to the Canadian energy sector. The fund is rebalanced on an equal weight basis semi-annually.
HEE writes covered call options on 100% of its portfolio of securities. This provides downside risk protections while generates extra income from the premium earned. This is the most liquid and largest fund amongst its peers.
Live Chart of the Horizons Enhanced Income Energy ETF – Symbol HEE
HOY Horizons Crude Oil Yield ETF HOY.to $N/A [N/A]
MER: 0.85%
HOY provides investors with exposure to the price of crude oil futures hedged to the Canadian dollar, less the ETF’s fees and expenses. The fund also uses a covered call option writing strategy on the Horizons Winter-Term NYMEX® Crude Oil ETF in order to mitigate downside risk and generate income.
HNY Horizons Natural Gas Yield ETF HNY.to $12.28 [+0.03]
MER: 0.85%
HNY provides investors with exposure to the price of natural gas futures hedged to the Canadian dollar, less the ETF’s fees and expenses; The fund also uses a covered call option writing strategy on the Horizons Winter-Term NYMEX® Natural Gas ETF in order to mitigate downside risk and generate income.
First Asset Can-Energy C. ETF OXF.TO $9.11 [+0.00]
MER: 0.66%
Can-Energy Covered Call ETF provides holders, through an actively managed portfolio, with quarterly cash distributions and the opportunity for capital appreciation. The fund has a portfolio of securities of the 25 largest issuers measured by market capitalization chosen from the S&P/TSX Capped Energy Index on an equal basis. The fund invests on an equal weight basis. lower overall volatility of returns on the portfolio than would be experienced by owning a portfolio of securities of such issuers directly.
Live Chart of First Asset Can-Energy C. ETF – Symbol OXF
Now that we have covered the strategy and the ETFs, remember that when you’re buying a covered call ETF, you are buying an actively managed fund. There is (hopefully) a skilled fund manager behind each one of them trading for you. These funds should effectively be considered as risky as equities and not part of a fixed-income strategy, so don’t be fooled by the high yield.