Attention Traders: Avoid These Alternative Income Duds

As interest rates bounce along near historic lows and dividend yields from major stock market indexes remain low, investors are considering alternative income strategies. And some are increasing risk to increase income.

This can be done by buying bonds with a longer maturity, a strategy that will result in large losses if interest rates eventually go up. Other investors are seeking higher income by buying lower quality bonds, for example, substituting junk bonds for high-grade corporate bonds. Junk bonds tend to trade like stocks, so when stocks fall, the high income could come with a large loss of capital. Investors buying lower quality dividend paying stocks to increase income face the same risk of large capital losses for small gains in income if stock prices fall.

In this environment, writing options can be a very appealing income strategy. Some investors shy away from trading options, so ETF sponsors came up with ways for investors to potentially benefit from options writing strategies such as covered calls without actually selling options themselves.

The iPath CBOE S&P 500 BuyWrite Index ETN (NYSE: BWV) is among the oldest funds that writes options, and it has a disappointing track record. Since inception in May 2007, BWV has provided investors with a total return of 11%. For comparison, SPDR S&P 500 (NYSE: SPY) has provided a total return of 19% over that time, while iShares Barclays 7-10 Year Treasury (NYSE: IEF) delivered a total return of 60% since BWV began trading.

A similar fund PowerShares S&P 500 BuyWrite (NYSE: PBP) has a similar track record. Since inception in December 2007, PBP has a total return of 4% while SPY added 21% on a total return basis.

A newer fund applies this strategy to gold. Credit Suisse Gold Shares Covered Call ETN (NYSE: GLDI) uses covered calls on GLD to generate income from gold holdings. Since inception in January 2013, GLDI has lost 10% while SPDR Gold Shares (NYSE: GLD) has lost 11.5%.

GLDI has cushioned the downside for gold investors but it will also limit the upside. Appreciation in the fund is capped at 3% per month. After fees and trading costs, the appreciation could be lower than that, even in months when GLD goes up more than 3%.

While 3% in a month sounds like a large move, GLD has actually gone up more than 3% a month 38% of the time since it began trading. The cap on appreciation could have a significant impact on GLDI when gold is in a bull market.

While these funds have the advantage of lower losses in a bear market, they have the disadvantage of lower gains in a bull market. 

This does not mean that writing options is a flawed strategy. It simply means that with fees and capped appreciation, it seems unlikely that investors will be able to beat a buy-and-hold strategy with ETFs that write options. A more active approach, writing options on individual stocks themselves, could deliver strong gains.

Options, like stocks, can be undervalued or overpriced. The strategy these funds use does not allow them to find the best options to sell based on the current prices since the managers are limited in their discretion and must follow the strategy defined in the prospectus.

Right now, for example, a covered call on Barrick Gold (NYSE: ABX) offers better potential gains than covered calls on GLD. An ABX call expiring on May 18 with a strike price of $20 is selling for about $0.43. If gold rises, the option could be exercised and covered call investors could see a total return of 7% in less than a month. Holders of GLDI are limited to a potential gain of 3% if gold prices recover.

Options writing is a great income strategy but the best returns will require finding the best individual trading opportunities at any given time. The upside will always be capped with options writing, but will often be greater than 3% if the right options are selected.

Consider writing options as an income strategy but use individual stocks and write individual options rather than buying a covered call ETF to maximize potential gains.

Note: If you are interested in generating income with options, but want help selecting the right options on the right stocks, check out my Income Trader service. Our latest trade is on track to make subscribers an annualized 129%. Click here to learn more.

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