Outcome ETFs: Using Options for Higher Dividend Yields

24/7 Wall Street Insights

• Options offer exponential leverage when trading the markets, but also carry commensurate risk.
• “Outcome” ETFs are an entire subcategory of ETFs that utilize several different types of options strategies that have emerged in recent years.
• While Outcome ETFs can deliver double-digit returns under the right market volatility conditions, their management fees are also proportionately higher.
• Dividends are the purest form of passive income, which is why we give our best dividend-paying stocks to 24/7 Wall Street readers. Click here for a free report on two high-dividend stocks.

In the movie Wall StreetCorporate raider Gordon Gekko (Michael Douglas) engages in insider trading based on information provided by young stockbroker Bud Fox (Charlie Sheen) by placing the following order: “Buy 1,500 July 50 calls. Start buying 1,000 blocks of shares and take it to $50. When it hits $50, give your friends a taste. Then call the Wall Street Chronicle and tell them Blue Horseshoe loves Anacott Steel.”

The order that Gekko places is for call options. Each option is equal to 100 shares, so in this case the option portion of the order is equal to 150,000 shares. Because the strike price is below $50, the options are what is called “out of the money,” so they probably only cost $250 each. So maybe $375,000 total, versus $6.75 million if the price were at $45.

Options: More Than Trading Speculation

Experienced traders and fund managers use options for a variety of applications beyond leveraged speculative trading.

Options and futures are an area of ​​the capital markets that exponentially increase the upside potential of a trade, but also increase the risk commensurately. The entire value of the option can become worthless if the strike price is above the underlying stock price for calls, or below it for puts, at expiration (usually the third Friday of the designated month).

Options, however, have a number of other applications besides speculating on leveraged trades. There is a large literature written by options strategists using options for hedging, income enhancement, and other fund management tactics. These techniques are often applied in commodity futures, foreign exchange, interest rate swaps, and with ETFs.

Option Strategies with ETFs

The use of options strategies to improve ETF performance has exploded in recent years, with 67 Outcome ETFs set to launch in 2023.

Exchange Traded Funds (ETFs) have been discussed in various guises in previous 24/7 Wall Street articles. Like mutual funds, they are typically designed to be representative of specific indexes that track different groupings within the capital markets. For investors who want to allocate funds to ride the returns of a particular index, the ETF is the vehicle of choice.

Innovative fund managers have developed a number of options-related strategies that have become useful tools to better achieve specific management objectives in the ETF arena. These ETFs have emerged and grown into a subcategory called “Outcome” ETFs. As an example of their rapid expansion, 67 new Outcome ETFs will be launched in 2023 alone. Some Outcome ETFs have begun to focus on specific non-indexed groups of stocks in the technology sector, such as AI, or even specific stocks, such as AMD.

In recent years, five general strategies of Outcome or Buffer ETFs have emerged:

Increase in income from covered calls

Covered call option strategies have become a popular tool to exponentially increase ETF returns.

This strategy is by far the most popular and widespread among Outcome ETFs. The fund engages in a monthly practice of writing out-of-the-money calls that, in most cases, expire worthless. The premium collected on the options increases the ETF’s monthly dividend yield above the profit earned by tracking the underlying index. The fund runs the risk of having to buy back the options if the index unexpectedly moves above the strike price and becomes at- or in-the-money before expiration. The fund can also use put options in bullish strategies. In the case of volatile Magnificent 7 stocks like Nvidia, special ETFs that use option strategies but are cheaper per share than even Nvidia’s post-split price often generate superior monthly returns, thanks to aggressive option strategies.

Some popular examples of Outcome ETFs that focus on higher income include:

• The S&P 500 Enhanced Options Income ETF (NYSE: JEPY)

• Global X NASDAQ 100 Covered Call ETF (NASDAQ: QYLD)
• YieldMax AI Option Income Strategy ETF (NYSE: AIYY)

Tail Risk ETFs

Tail Risk ETFs use options as a strategy to limit downside risk when selling at market.

These ETFs essentially track the underlying index, but maintain hedging positions. These take the form of deep out of the money puts to protect against a sudden market sell-off or crash, as recently seen with the market sell-off in early August.

Some examples of these are: Global X S&P 500 Tail Risk ETF (NYSE: XTR) And Pro Shares VIX Short Term Futures ETF (CBOE: VIXY).

Collar ETFs

Collar ETFs can employ option spread strategies involving both call and put options.

To meet the demand for less market volatility, Equities combined with put spread collars have become a popular way to create more conservative, lower volatility investments. Collar ETFs are named for their use of a ladder of collars that expire over 3 consecutive months, with the goal of creating a hedged equity experience. The put spreads typically involve two different strike prices of puts or being long on a put while selling a call option.

An example of a Collar ETF would be the Simplify Hedged Equity ETF (NYSE: HEQT).

Risk-Managed Income ETFs

Risk-managed ETFs create an arbitrage scenario, where a profit is made by selling a call option for more than the cost of a put option, while reducing the fund’s volatility.

In another use of option spread strategies, a Risk Managed Income ETF acquires out of the money puts and sells at the money calls. The ETF earns the difference between the premium of selling the calls versus the cost of buying the puts. An example of a Risk Managed Income ETF would be the Global X NASDAQ 100 Risk-Managed Income ETF (NASDAQ: QRMI).

Buffer ETFs

Buffer ETFs deploy options on a 12-month cycle, combining 9-20% downside risk mitigation with the ability to ride the rise of an index.

A hybrid twist on the Enhanced Income and Risk Managed Income ETFs is the Buffer ETF. Based on a defined 12-month range, Buffer ETFs add a risk mitigation component to their options strategy to better address investor concerns by deploying options to protect against a fixed percentage of downside. Each month a different ETF is offered with risk mitigation between 9-20% downside against an index sell-off.

For example, PGIM offers an ETF series with a 12% buffer, the PGIM US Large Cap Buffer 12 ETF August (CBOE: AUGP)and the 20% PGIM US Large Cap Buffer 20 ETF August (CBOE: PBAU).

Asset manager BlackRock offers three different Buffer ETFs:

• iShares Large Cap Max Buffer Jun ETF (CBOE: MAXJ)

• iShares Large Cap Deep Buffer ETF (CBOE: IVVB)
• iShares Large Cap Moderate Buffer ETF (CBOE: IVVM)

All 3 are new and dated July 31, 2024.

Pros and cons

Outcome ETFs can deliver significantly higher returns, while the costs for their managers are exponentially lucrative.

Depending on how aggressive the Outcome ETF is, some returns can be impressive double digits, with some even as high as the 20-30% range. These numbers can be generated provided market volatility is sufficient to justify the higher premiums from sell calls.

On the other hand, the management costs for such stressful activities and monitoring are also proportionally higher: some costs are even four times higher than those of passive ETFs.

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