Read the article ‘A Good Option: Covered-Call Funds’.

A Good Option: Covered-Call Funds

Covered-call funds sell call options, which give the buyer the right to purchase a stock at a set price (the strike price) within a certain period of time. The call options are “covered” because the fund owns the stocks it’s selling options on. Other option-income funds sell options on indexes. In either case, the funds collect premiums on the calls they sell, income that is distributed to shareholders. Distribution payouts should roughly match the income generated from the premiums plus the appreciation in the stocks. Most of these funds offer monthly payments that run 7% to 9%

These funds work best in stock markets that are turbulent, since options premiums are higher when volatility goes up, but can also be successful in flat or slowly rising markets. That bodes well for 2016, in which geopolitical risks, a presidential election, and expected Fed rate hikes could create extra turmoil, but a strengthening U.S. economy should keep stocks from sinking.

“They are excellent vehicles for this kind of market,” says Charles Earle, who runs exchange-traded and closed-end fund research at Gates Capital. “These strategies really should be used tactically in different market periods.”

If stocks fall, the premium cushions losses, but doesn’t prevent them. And if stocks shoot up, the option will be exercised and the fund won’t participate in the gain above the strike price. “Selling calls limits your upside,” says Kevin Kelly, chief investment officer at Recon Capital Partners, which offers the Recon Capital Nasdaq 100 Covered Call ETF (ticker: QYLD), up 7% this year. But the calls limit downside, too. For example, if the fund took in a 2.5% options premium and the market falls 5%, the fund will only go down 2.5%, says Kelly…

a. According to the article, state the positions in call option and its underlying stock for a covered-call fund.

b. Covered-call funds ‘work best in stock markets that are turbulent but can also be successful in flat or slowly rising markets’. Explain whether you agree with this statement.

c. Kevin Kelly, chief investment officer at Recon Capital Partners, said that ‘selling calls limits your upside but the calls limit downside, too’. Draw a well-labelled diagram to show the profit and loss of a covered-call strategy and discuss whether you agree with Kevin Kelly.