2023-08-23 10:37:50 ET
Summary
- KLIP is a covered call strategy ETF that purchases shares of KWEB and simultaneously writes call options.
- This article will teach you how they write calls to generate premium income and uses examples to demonstrate this practice.
- Overall, KLIP has a reasonable fee for the strategy of both the fund and the underlying asset it holds.
- The risk-adjusted returns of KLIP are better than KWEB (its underlying asset) which is consistent with historical findings.
All figures are in unless otherwise noted.
Net Assets (at August 22, 2023): $69,763,141
Current Yield (at August 22, 2023): 55.14%
Introduction
Covered call strategies are gaining increasing popularity, particularly among individuals seeking consistent income during their retirement years. These strategies offer a compelling proposition with their robust dividend yields, making them appear highly alluring. As an investor in these ETF products, it's crucial to gain a comprehensive understanding of their mechanics, potential ramifications, and the nuances that set various covered call approaches apart.
First, we must understand what a call option is: A call option is a financial derivative that gives the holder the right, but not the obligation, to buy a specific quantity of an underlying asset at a predetermined price (the strike price) within a specified period (until the option's expiration). Imagine you really want to buy a toy that costs $10, but you're not sure if you'll have enough money by the time you want to buy it. So, you ask your friend if you can pay them $2 now in exchange for the promise that they'll sell you the toy for $10 later, no matter how much it costs them. This is kind of like a special agreement and the $2 you paid is like a premium. The holder of a call option is said to be 'long' whereas the opposite side is said to be 'short' or to have 'written' the call option.
The long side of a call option must pay a 'premium' to enter into this special agreement because as mentioned, they have the right, not the obligation to purchase the underlying asset. The holder pays this premium to the person who wrote the call or the short side of the call because, unlike the long side of the call, they don't have the right, they have the obligation to sell the underlying asset to the long side if the long side chooses to exercise their option.
One final key consideration to note; 1 call option will typically represent 100 shares of the underlying. For example, if you purchase one call option on a company's stock, it gives you the right to buy 100 shares of that company's stock at the specified strike price.
You might be asking yourself, what causes the premium to go up or down? This is a great question and it's critical if you're considering an investment in Kraneshares China Internet And Covered Call Strategy ETF (KLIP). There are 6 key factors that affect the premium:
Factor | Relationship With Call Premium (Price) |
Underlying Asset Price | Increases as Underlying Asset Price Increases (+) |
Strike Price | Decreases as Strike Price Increases (-) |
Time to Expiry | Increases as Time to Expiry Increases (+) |
Volatility | Increases as Volatility Increases (+) |
Interest Rates | Increases as Interest Rates Increase (+) |
Dividends | Decreases as Dividends Increase (-) |
KLIP Strategy
KLIP purchases shares of the KraneShares CSI China Internet ETF (KWEB) and simultaneously writes call options where the underlying asset is KWEB. This is the mathematical definition of a covered call: Covered Call = Long Stock + Short Call.
Effectively, they purchase shares of KWEB and at the same time, they are agreeing to sell KWEB at a different strike price. Here is a theoretical example of how this works in practice.
Imagine you're running an investment fund called KLIP, and you're interested in starting a covered call strategy on an ETF called KWEB. You want to benefit from potential gains in KWEB's price while also generating income. Here's how you could use a covered call strategy with KWEB:
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Buying KWEB Shares:
- You decide to purchase 1,000 shares of KWEB at $27 each. This means you've invested $27,000 in total to own these shares.
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Selling Call Options:
- Now, you sell 10 call options on KWEB. Each option covers 100 shares, so you're effectively selling the right for someone else to buy 1,000 shares of KWEB from you.
- These call options have an expiration date of 150 days from now, and the strike price is set at $30. For giving this right, you receive a payment called the "call premium."
- In this case, the call premium is $1.89 per option contract, totaling $1,890 for the 10 contracts. After accounting for transaction fees, you're left with the net premium income.
Now, let's explore the two possible scenarios that can happen over the 150-day period:
Scenario A) Price of KWEB Stays Below $30:
- Throughout the entire 150 days, the price of KWEB remains below $30.
- The person who purchased the call options won't exercise their right to buy shares from you at $30 because it's cheaper to buy them from the market.
- In this case, you keep the 1,000 shares of KWEB that you initially bought, and you also retain the $1,890 in premium income.
Scenario B) Price of KWEB Rises Above $30:
- At some point during the 150 days, let's say the price of KWEB rises to $32.80.
- The holder of the call options sees this opportunity and decides to exercise their right. They buy 1,000 shares of KWEB from you at the agreed $30 per share, even though the market price is higher.
- After buying the shares from you at $30 each, the holder can sell them on the open market for $32.80 each, making a profit.
- In this case, you keep the $1,890 in premium income, and you also receive $30 per share on the 1,000 shares you sold. However, note that you sold these shares at $30 as per the agreement, missing out on potential gains beyond that price.
The covered call strategy allows you to potentially benefit from both holding the shares and the income generated from selling call options. It's a way to balance potential gains with the risk of selling shares at a predetermined price, depending on how the market behaves.
If you're a visual learner, the horizontal axis here is the price of KWEB and the vertical axis is the profit. Note the limited upside:
In summary, KLIP managers own KWEB and they enter into agreements to sell KWEB at a price by writing call options. In exchange for entering these agreements, they get paid by the holder of the call option. They use this premium that's paid to them to pay a dividend to shareholders of KLIP.
Recall that the value of a call premium goes up when the volatility of KWEB goes up. KWEB tracks the CSI Overseas China Internet Index , which consists of China-based companies whose primary business or businesses are focused on Internet and Internet-related technology. The nature of KWEB is volatile, especially in relation to other indices such as the SPY . The historical volatility of KWEB is 44.37% compared to the SPY at 9.67%. Therefore, the premium on KWEBs call options are much higher than the equal type of option on the SPY (assuming all things are unchanged).
The fact that volatility is much higher means that the premium income they earn is also much higher than if they were writing the same call options on the SPY. With higher volatility also comes the chance that shareholders of KLIP miss out on any potential sizeable capital gains. Imagine in our scenario B that the price rose to $40 instead of $32.80 - KLIP would have missed out on ~25.4% of potential capital gains as opposed to if they never wrote the call option.
In summary, covered call strategies have limited upside and limited downside (only occurs if the underlying asset price falls to $0). In the case of KLIP, they benefit when the share price rises but not by more than the strike price written by the managers.
As of August 21, 2023, KLIPs holdings are:
I added columns G, H, and I so you could see what options they have and how they are writing their calls. The expiry for most of these options is next month!
KLIP Performance And Fee
If you invested in KLIP when it opened on January 12, 2023 , you would be up ~8.52% if you reinvested the dividends. Meanwhile, over the same duration, KWEB would have lost ~5.64%. The income provided from writing calls has provided a shield from the losses on KWEB (more like scenario A in our example) and has even provided a positive return. The standard deviation (volatility) for KWEB is 45.76% versus 16.57% on KLIP if you started your investment on January 12th, 2023. These findings are consistent with the historical findings that show covered-call strategies typically have lower volatility and similar returns to the S&P 500 means they often have better risk-adjusted returns.
KLIP charges an MER fee of 0.95% which is higher than some other conventional covered call ETFs such as QYLD (0.6%) and XYLD (0.6%). Considering that the average MER for covered call ETFs is 0.80% in the United States, I think KLIPs fee is reasonable given the higher volatility on its underlying asset and the specialty strategy you're getting exposure to through KWEB.
Conclusion
If you're an investor who is looking for exposure to China-based companies whose primary business or businesses are focused on internet and internet-related technology, while also collecting a decent yield, then KLIP isn't a bad option. Now that you have a better understanding of how KLIP can pay such a high dividend yield I would like to remind investors that they should consider the high volatility of KLIP before making an investment decision as this may not be an appropriate investment for someone approaching/in retirement (as this tends to be a time when you're looking to reduce volatility).
Disclaimer: This isn't investment advice nor should it be considered investment advice.
For further details see:
KLIP: Understanding The Covered Call Strategy And How It Works