Look to covered calls to weather storm, says BMO

Scott Longley

a man and woman kissing under an umbrella

So, let's say you are an expert investor who has worries over the recent spate of stock market volatility and you are well aware of the potential for said up and downs to limit your long-term returns.

In such circumstances, who you gonna call? Well, actually, it's a covered call overlay you will be looking for. That, at least, is the advice of Morgane Delledonne, ETF investment strategist at BMO Global Asset Management, who suggests that one way to reduce downside risk for their portfolio is to look at income-producing investments.

This will act as a "downside buffer" and enhance yields, thus lowering the volatility of returns. "This is a distinct advantage in uncertain times," she says.

Mr buy-write

For ETFs, the potential is there to use a covered call overlay. This involves selling call options against an equity index in exchange for an immediate additional cash flow - that is the call option premium - on top of the stock dividend, increasing the overall yield of the portfolio.

To repeat, this is for expert investors only. But for those still interested, Delledonne provides a chart comparing the implied volatilities of S&P 500 call options at different strike prices before and after the recent October sell-off.

chart, line chart

"The increase in over­all implied volatil­i­ty following the market correction (upward shift of the implied volatility curve), suggests that market participants expect volatility on the S&P 500 index to remain elevated in the month ahead.

"There is more demand for put options implying that market sentiment is becoming more negative on the upside potential for the S&P 500 index. Overall, option pricing suggests that the US market has possibly already peaked."

To background her advice, Delledonne points out that developed markets ETFs have recorded the largest global net outflows month-to-date, while relatively cheaper emerging market assets gathered net inflows.

"Market corrections are likely to become more frequent in the late-cycle phase, and volatility could erode long-term returns," she adds.

But BMO remains "cautiously optimistic" that global stock markets will weather the storm.

"Current equity valuations are stretched and in line with levels seen prior to the 2007 crisis but corporate profitability is high overall," she says. "Globally, companies exhibit a lower equity multiplier than before the past two crises, as well as lower financial leverage. Economic activity is strong, evidenced by high US manufacturing PMIs, albeit losing momentum."

Yet volatility and uncertainty walk among us once more spelling the end of the prolonged period of market calm. "The upcoming US mid-term elections, the ongoing Brexit negotiations, the Italian fiscal challenges, the increase in US interest rates and the threats of global trade wars, are all likely to continue to act as disruptive factors for global markets," says Delledonne.

All of which suggests the advice for experts and novices alike is, as has been said recently on these pages, fasten your seatbelts.


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