What it means
The most common strategy is the covered call. The fund owns a portfolio of shares and sells call options on them, which give the buyer the right to buy those shares at a fixed price.
In return the fund receives a premium, which becomes income. Some option income funds use other methods, such as selling put options backed by cash.
All of these rely on collecting premium from buyers who want protection or exposure. The fund keeps the premium whether or not the option is exercised, which is why the income is relatively steady.
The attraction is a higher regular payout than shares alone provide. In flat or gently rising markets, the premiums add to the return and can cushion small falls in price.
Investors seeking income, such as retirees, find that appealing. The cost is capped upside.
If the market rallies sharply, the shares may be called away at the agreed strike price and the fund misses the gain above that level. If the market falls heavily, the premium offers only limited protection, so the fund can still lose substantially.
Market conditions change the picture. When volatility is high, option buyers pay larger premiums, so the fund collects more income, but the same conditions raise the chance that shares are called away or fall sharply.
When volatility is low, premiums shrink and the income from the strategy falls with them. Fees and tax treatment also deserve attention.
Active option strategies generate trading costs and management fees, and the income may be taxed differently from ordinary dividends depending on the rules where the investor lives. Anyone considering such a fund should check how much of the payout comes from premium and how much is a return of the investor's own capital.
In practice
Real-world examples.
Example
A retiree puts $200,000 into an option income fund to receive monthly payments. The fund pays out most of its premium income, and she uses it to cover living costs. She accepts that the fund will lag in a strong bull market. She keeps the rest of her savings in ordinary shares to capture the growth.
Example
A charity invests part of its reserves in an option income fund to raise its annual income. The finance committee compares the yield with the yield on bonds and decides what proportion of its reserves it can place in the fund. The committee also asks to see how much of the payout is premium income.
Example
A financial adviser explains to a client that a rising market is the main danger for this type of fund. If shares jump 20%, a covered call fund might gain far less, because the shares can be called away.
Formula
Calculation
Distribution yield = (dividend income + option premium income) / fund net asset value
A fund has net assets of $10,000,000. Its shares pay dividends of 2% of that value, which is 10,000,000 x 0.02 = $200,000. Over the year it collects call premiums of 6%, which is 10,000,000 x 0.06 = $600,000. Total income = 200,000 + 600,000 = $800,000, so the yield = 800,000 / 10,000,000 = 8%. If the market rose 15% but the calls were struck 5% above the starting level, the fund's price gain would be limited to about 5%, so its total return would be about 5% + 8% = 13% rather than 15% + 2% = 17%.Case study
Seen in the real world.
Heron Lake Foundation is a fictional charity that needed $400,000 of income a year from an $8,000,000 investment pool. Dividends and bond interest alone were not quite enough, and the trustees did not want to sell investments to make up the gap.
The treasurer allocated $2,000,000 to an option income fund yielding about 7%, which produced 2,000,000 x 0.07 = $140,000 a year. This lifted the total income from the pool toward the target without selling any assets, although the amount depends on market conditions and is not guaranteed.
In this illustrative story the fund trailed the share market in a strong rally but held up better in a flat year. The treasurer concluded that it served its purpose as a source of income, and she limited it to a quarter of the pool to control the cost of missing the upside.
Watch out
Common mistakes.
- Treating the high yield as free money, when it is paid for by giving up part of the gains in a rising market.
- Assuming the fund is protected against falls, when the premium cushions only a small part of a large decline and the investor still bears most of the loss.
- Ignoring the possibility that some payouts are a return of the investor's own capital rather than true income.
Questions
People also ask.
How does an option income fund make money?
By selling options on its holdings, collecting the premium and passing it to investors alongside dividends.
Is a covered call fund safer than owning shares?
It can be a little less volatile because of the premium, but it still carries most of the market's downside risk.
Who might use these funds?
Investors who prefer regular income and accept limited upside, such as retirees or charities.
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