Covered calls explained: Why options design matters in covered calls and Fidelity’s approach

Covered call strategies are gaining interest for their potential to enhance overall cash flow through option premiums. While they aim to offer extra cash flow over traditional strategies, they also involve additional risks. It’s important to understand how the design of the options overlay strategy in a covered call ETF shapes the income, risk and return profile.

Why design matters

Fidelity’s covered call strategy takes a rules-based approach that aims to diversify call options with unique strike prices and expiration dates, while still allowing room to potentially capture some upside. The design of the options strategy, specifically the strike prices, expiration dates and how much of the portfolio is covered by the options, plays a critical role in the effectiveness of a covered call strategy.

Covered calls are more than strategies that can be used to potentially enhance cash flows; they can also be viewed as risk management tools that can potentially help mitigate overall portfolio volatility without adding duration risk.* A systematic short exposure to call options, combined with an equity portfolio, can enhance income opportunities while providing market exposure and growth. There are characteristics of an option portfolio that play a key role in total portfolio performance, and these characteristics should align with your income and growth investment goals.

 *Duration risk is the risk that a bond’s or a fund’s price will change because of interest rate movements, with longer durations being more sensitive to those changes. The longer the duration, the bigger the price change when rates move.

Some of the main characteristics to consider include the following:

Strike price selection

The strike price determines how much upside you’re potentially getting in exchange for a premium. Typically, the higher the strike price, the smaller the premium, because a higher strike price allows for greater participation in up markets, and the probability of it being exercised can typically be lower. While the relationship between strike price and premium can depend on multiple factors, the strike price relative to market price (or “moneyness”) can be defined as follows:

• In-the-money (ITM, strike price less than market price) strikes generate higher premiums but little to no upside.
• At-the-money (ATM, strike price approximately equal to market price) strikes generate higher premiums but limit upside sooner.
• Out-of-the-money (OTM, strike price greater than market price) strikes allow more room for capital appreciation but offer lower premiums.

For example, the Cboe S&P 500 2% OTM BuyWrite Index sells calls 2% above market price.

Expiration date

Shorter-dated options

• aim to capture more frequent premium income
• may be more sensitive to volatility spikes, which can increase premiums

Longer-dated options

• may offer competitive premiums
• may be less sensitive to short-term volatility

Fidelity’s covered call approach

Fidelity Equity Premium Yield ETF (FEPY) and Fidelity Equity Premium Yield ETF Fund (which invests in units of FEPY) take a rules-based approach that seeks to enhance income through covered calls, while aiming to maintain equity market participation and help reduce overall portfolio volatility. Here are the attributes of this popular strategy:

Uses liquid, transparent index options

FEPY sells S&P 500 Index call options that are:

• exchange-traded and centrally cleared, to help ensure high liquidity and transparency
• typically cash-settled and “European style,” meaning they can only be exercised at expiration, unlike single-stock options, which can be exercised anytime

This approach could potentially help manage volatility and mitigate some risks associated with over-the-counter (OTC) options or individual stock options.

Rules-based method

FEPY follows a systematic, rules-based approach to selling options:

• This “always on” method helps avoid trying to time the market, which can lead to emotional decision-making.
• It aims to deliver income and potentially reduce the risk of poorly timed decisions, which could contribute to a more consistent investment experience.

Diversified option laddering

The strategy aims to manage risk and pursue consistent income in the following ways:

• spreads option trades across different strike prices and dates to balance risk, yield and return
• covers 100% of the portfolio with options to help manage risk and/or generate income
• aims to manage income across various market conditions through this diversification

Balancing income and capital growth

The “moneyness” of options can determine the balance between potential cash flow and capital appreciation.

• Strike prices that are further out of the money can allow the portfolio to capture some market upside while still generating income.
• Strategies that sell options at-the-money may generate higher income, but may inhibit long-term capital growth due to higher risk of options being exercised.

Rebalancing for consistency

FEPY systematically rebalances its options positions to provide investors with similar portfolio risk attributes regardless of entry point.

Fidelity Equity Premium Yield ETF (FEPY) is a covered call ETF designed with the aim of providing income, reducing overall portfolio volatility and maintaining equity exposure, while offering the potential for long-term capital growth.