In the first of a two-part series, we share insights on an investment approach we employ in portfolios to help achieve optimal outcomes.
Seeking equity income in choppy markets
Today’s income investors face a tough choice – hold cash and core bonds paying low real rates or extend into higher-yielding markets with more risk and less liquidity.
The actively managed JPMorgan Equity Premium Income ETF (JEPI)1, one of the world’s largest and fastest-growing actively managed equity ETFs with over A$24 billion2 assets under management as of 31 December 2022, seeks to resolve the dilemma by pursuing opportunities for consistent monthly income and potential appreciation, with lower volatility than the US stock market3. Read more >
Options can play a variety of roles in different portfolios4. In our equity premium income ETF strategy, we employ an options strategy to help us manage risk and optimise income. Let’s consider some basics of call options.
What are call options⁴
- An option is a contract that provides a buyer with the right, but not the obligation, to buy or sell a specific financial product known as the option's underlying instrument or underlying interest. For equity options, the underlying instrument is a stock, ETF or similar product. The contract itself is very precise. It establishes a specific price, called the strike price, at which the contract may be exercised, or acted upon. Contracts also have an expiration date, a period that could be as short as a day or as long as a few years. When an option expires, it no longer has value and no longer exists.
- If investors buy a call, they have the right to buy the underlying instrument at the strike price on, or before the expiration date. On the other hand, selling a call option gives the seller the obligation to sell the underlying instruments at the strike price. In return, the seller is paid a premium.
- A call option is in-the-money if the current market value of the underlying stock is above the strike price of the option. The call option is out-of-the-money if the stock is below the strike price5. For example, if a stock is trading at $50 per share, while the investor has a strike price at $70 and owning a $70 call, that option would be out-of-the-money by $20.
How do covered calls work⁶
- A covered call strategy comprises writing a call that is covered by an equivalent long stock position. It provides a small hedge on the equity and allows an investor to earn premium income without taking on additional risk, in return for temporarily forfeiting much of the stock's upward potential7.
- The premium received adds to the investor's bottom line regardless of outcome. It offers a small buffer in the event the stock slides downward and can help boost returns when it rises.
Conclusion
Combining prudent, disciplined call writing with an active equity portfolio can help solve a number of potential needs8. The pairing can serve as a low volatility equity substitute, a yield-generating supplement for credit or a component of a more diversified income-generation strategy. Read more >
Provided for information only based on market conditions as of date of publication to illustrate general investment process, not to be construed as offer, research or investment advice. Forecasts, projections and other forward looking statements are based upon current beliefs and expectations, may or may not come to pass. They are for illustrative purposes only and serve as an indication of what may occur. Given the inherent uncertainties and risks associated with forecast, projections or other forward statements, actual events, results or performance may differ materially from those reflected or contemplated. Risk management does not imply elimination of risks.
Diversification does not guarantee investment return and does not eliminate the risk of loss.
1. JPMorgan Equity Premium Income ETF (JEPI) is the marketing name of the JPMorgan Equity Premium Income Active ETF (Managed Fund).
2. Source: Morningstar, 31.12.2022, US dollar/Australian dollar spot rate 1.4695.
3. For illustrative purposes only based on current market conditions, subject to change from time to time, and are not to be construed as offer, research or investment advice. Not all investments are suitable for all investors. Exact allocation of portfolio depends on each individual’s circumstance and market conditions.
4. Source: “What is an Option?”, The Options Industry Council, January 2023.
5. Source: Basic Options Terms Explained: In-the-Money, At-the-Money, and Out-of-the-Money”, The Options Industry Council, January 2023.
6. Source: “Covered call (Buy/Write)”, The Options Industry Council, January 2023.
7. There is a potential to forego some capital appreciation as a result of writing out-of-the money S&P 500 Index call options. The Investment Manager (Portfolio Manager) seeks to achieve the stated targets/objectives. There can be no guarantee the objectives/targets will be met.
8. Source: “New Pathways to Income: Optionality”, Allocation Spotlight Series, J.P. Morgan Asset Management, 14.10.2021.
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