RYLD - IWMY: 57% Yield And Rapid Decay

2024-01-04 17:27:35 ET

Summary

• Option popularity has skyrocketed, and the funds engaging in this arena have proliferated.
• Why delay gratification with LEAPs or monthly options when you get 57% yield via shorter term option selling?
• Defiance R2000 Enhanced Options Income ETF's brief history shows you the "why."

Note: This article was written pre-market on January 4, 2024.

Every bull market ends with a new paradigm. Well, at least the crowd believes it is a new paradigm. This one appears to be gunning for two distinct ones. On one hand you have the Magnificent 7, full of AI promise, and on the other you have this obsession with options. It is the latter we will talk about today and how it pertains to the new Defiance R2000 Enhanced Options Income ETF ( IWMY ). But first, a little primer on our obsession number two.

Option Volumes

In the scary times of COVID-19, there was a new hobby born, speculating through options. The chart below is from June 2020.

If you thought that vertical line was an anomaly, you were really wrong. We just went higher and higher. Simultaneously, the masses developed a love for options expiring on shorter and shorter timeframes. Note how weekly options remained at a low percentage after they were introduced, but really exploded post 2020. Chart below runs till Q1 2023.

On these options, on the call side, you have, of course, the buyers (generally speculators) and sellers (generally looking to hedge or create income). Enter IWMY.

The Purpose

IWMY aims to achieve consistent monthly yield distributions for investors coupled with equity market exposure to the Russell 2000. IWMY is an actively managed exchange-traded fund (“ETF”) that seeks enhanced income, constructed of treasuries and Russell 2000 index options. The strategy’s objective is to generate outsized monthly distributions by selling option premium on a daily basis. The fund uses daily options to realize rapid time decay by selling in the money puts.

Rapid time decay to generate income is apparently a concept now. Why did we all not think of this before to generate a 57.22% yield?

Well let us look at what the fund is actually doing before we reach a conclusion. The fund has close to $102 million in total assets, and those appear to be invested in two different Treasury notes. One matures in August 2024 and the other in November 2024.

Of course, the fund is not around to make 5% a year on cash, as we have plenty of funds lined up just for that. No, the fund then sells puts on the Russell 2000 (RTY).

The symbol above can be found on Yahoo Finance, and that is helpful for those trying to understand how these prices move.

Note that since these are weekly expiring options, it is possible that you might not find this post option expiration on January 5, 2024. For context on how those options have moved, here is the change in Russell 2000 over the past 5 days.

The idea here is to generate "income," and we use this pretty loosely, by capitalizing on theta decay over extremely short timeframes. Anyone who has spent any time understanding options knows that this method provides very little protection against sudden downside moves. Like the one we had in the last week. IWMY's price has dropped 8.33% over the last five days. Some of that had to do with the large distribution which was doled out (see opening cap on December 28), but the prices have moved lower overall.

Since inception, if you bought and held the iShares Russell 2000 ETF ( IWM ), you would be up 18%. IWMY is down 4.56%. Total return was 18.47% for IWM and 1.49% for IWMY.

Outlook

We really could not have dreamt up a more fitting two month return for this fund to illustrate the dangers of this strategy. The fund launched right into the depths of despair for small caps at the end of October 2023, and as corresponding Russell 2000 and IWM went vertical, the fund was left behind. This is how put selling works, or rather does not "work." The problem compounds here as the fund has to make this choice on a constant basis. When it launched, it would sell puts at around the 1650 level. Having "dodged" most of the appreciation from 1,650 to 2,050, it is selling options at the 1,975 level.

So if we have a sudden crash in a week back down to 1,650, the fund will have gotten most of the downside (minus the small premiums). IWM will be flat over the three month timeframe, and IWMY will be down big. What more could you ask for while chasing yield?

Verdict

You can do weekly options for yourself. You can use it to get methodically long when indices or the stock you love are oversold. Once you get long, you can ride things up and when you believe the rally is over, you can sell weekly call options. This simple method will at least not mess up your returns. You won't be buying high and selling low. You can even tailor the calls or puts to degree of your bullish or bearish sentiment.

For example, we have often sold deep in-the-money calls to force us to be long only at an attractive price (See, Once I Had Love, And It Was A Gas ). But IWMY cannot do all of this. It will sell the 1,650 index put, and then the next time it might sell the 1,975 put. It is indifferent to where the index is, how overbought it is and what the fair value might be. For example, if the managers believed Russell 2000 is fairly worth 1,700, they would have to stop all put selling until it went down near that. The reason is that weekly put option premiums would be zero if you went more than 5% away from the money. Well, if they waited, there are no premiums to sell and no "income" to give you.

The reverse also applies. If they thought Russell 2000 was fairly valued at 2,500, they cannot just buy and hold the index. They have to do this put-selling, which forces them to constantly time the wiggles and squiggles. Our thinking is that in a year where we expect extreme volatility, this will underperform the Russell 2000. Already it is trailing the IWM by 17%, or close to 90% annualized.

We rate the IWMY fund a Strong Sell. This is one step lower than Global X Russell 2000 Covered Call ETF ( RYLD ), which blindly sells monthly call options and is rated as a Sell.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.

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