Prototype Covered Call Sector Fund Makes Debut

NEW YORK ( TheStreet) -- Exchange-traded fund provider Horizons just launched the S&P Financial Sector Covered Call ETF ( HFIN), the firm's second U.S. fund. Horizons is a big player in the Canadian ETF market.

The covered call strategy is intended to generate income beyond just owning the stocks -- or in this case an index -- by selling call options. Specifically, a call option allows the buyer the right but not the obligation to buy stock at the option's strike price if he so chooses. The seller of the option is obligated to sell stock he owns at the option's strike price if the option buyer wants to buy. The option seller receives a premium which can be extra income from holding the stock.

As an example, an investor might buy 100 shares of Johnson Controls (JCI) for $50 per share. He might then sell a January call with a strike price of $55 for 30 cents per share. When the option expires in January, the stock will be either above or below $55. If it is above $55, then the option buyer will exercise his option to buy the stock at $55, obligating the option seller to sell his stock.

If the stock is below $55, then the option seller likely gets to keep his stock and would still have the 30 cents from selling the option. An investor who sells call options is looking for extra income and hopes that the stock doesn't go above the strike price before expiration. In the example above, if Johnson Controls went to $60, then the option seller would have forgone another $5 per share in price appreciation to make 30 cents in option premium.

There can be much more nuance to selling covered calls; the above is meant to address the basics of the strategy.

As implied in HFIN's name, the underlying equity portfolio is the financial sector of the S&P 500 captured in the long-standing Financial Select SPDR (XLF), but HFIN overlays the covered call strategy.

HFIN will sell out of the money monthly call options on all of the components of XLF for which there are options trading and intends to pay out a monthly dividend from the collected options premiums. Horizons believes it can generate more option premium for fund holders by selling options against individual stocks as opposed to simply selling XLF call options. HFIN now has calls sold against 72 of the 86 stocks in the fund.

The equity portfolio is dominated by the same large-cap financials as XLF, including JP Morgan (JPM), Wells Fargo  (WFC) and Berkshire Hathaway Class B  (BRK.B), which all have 8% weightings in the fund.

For now. there is no dividend information available for the fund, but if it can generate a reasonable and consistent dividend, then one way to use the fund could be as one piece, a slightly less volatile piece of the financial-sector allocation of a diversified equity portfolio.

The risk is what happens when call options are rolled forward to the next month. The calls sold will generally be slightly out of the money. If in a given month, Wells Fargo goes up 10%, the fund will buy back the now deep-in-the-money calls which will be expensive and replace them with new calls for the following month which will be slightly out of the money.

Buying back Wells Fargo calls 10% in the money could cost $4 based on current prices, and the new option sold might bring in only 30 to 40 cents. The loss on this rolling forward would be reflected into the net asset value of the fund and be a drag on returns.

;A similar problem could arise if an option is assigned early before the roll forward can happen. The fund might have Wells Fargo called away at $45 and then have to buy it back in the open market for $49 as a hypothetical example.

A more conceptual risk to the fund is that the market continues to rocket higher as it has been doing. Covered call strategies should be expected to lag behind the market during large rallies.

A covered call strategy can make sense when the market is up a little or down a little, and historically the average gain for the market in the year following a 25% or greater rally is between 5 and 6%. That could make HFIN's debut very timely.

At the time of publication, the author held no positions in any of the stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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