A common problem for investors who try to implement the covered call strategy with a small amount of capital is the lack of diversification. With the relatively high commissions charged by Australian brokers for option trades, it does not make financial sense to do this strategy with less than $10,000 per position. The lack of diversification can be a significant risk as shown in the following example.

Let’s compare two investors who both do covered calls with $10,000 per position. Investor A has a capital of $20,000 so he would be able to have a maximum of 2 stocks in his portfolio. Investor B has a capital of $100,000 so he would be able to have a maximum of 10 stocks in his portfolio. If both Investor A and Investor B had a similar sized position in the same stock which subsequently fell in price by 50%, this would create a 25% drawdown in Investor A’s account but only a 5% drawdown in Investor B’s account.

A quick way for small investors to get diversification would be through Exchange Traded Funds (ETF). BetaShares, a leading provider of ASX traded ETFs has created an ETF called the Equity Yield Maximiser Fund (or YMAX) which writes covered calls over the top 20 Australian stocks i.e. those listed on the ASX 20 index. The YMAX investor will get exposure to 20 stocks which can help to reduce his diversification risk. However, this does not mean that investors will get equal exposure to those 20 stocks as YMAX mirrors the ASX 20 index which is a weighted index. From the listing of the top 10 stocks in the YMAX portfolio below, we can see that the big 4 banks and BHP make up 56.5% of this portfolio.

Source: http://www.betashares.com.au

Another point to note is the heavy weighting to the financial and materials sectors. From the sector allocation chart below, we can see that 53.9% of the YMAX portfolio is in the financial sector and 16.3% is in the materials sector. Defensive sectors such as consumer staples, telecommunications services and Healthcare only make up 22% of the portfolio.

Source: http://www.betashares.com.au

Personally, I like to construct my own portfolio allocation based on my risk profile. For example, I prefer the income portfolio in my retirement account to have a heavier weighting to defensive sectors such as consumer staples and healthcare. Hence the YMAX portfolio allocation would be still be too “high risk” for me. However, it would most likely be a lower risk portfolio compared to a portfolio comprising of two stocks (especially if they are in volatile sectors).  This is food for thought for the smaller covered call investors, and may well be worth further consideration.

As this ETF sells covered calls, it is able to provide attractive quarterly income that exceeds the dividend yield of a portfolio of the underlying shares. Some of this income of course will be used to pay management fees of 0.59% and expenses of up to 0.2%. For a $20,000 investment, this could amount to $158 per year, which would still be far less than what one would normally pay in brokerage to do covered calls over a diversified portfolio of a similar size. Anyone interested in YMAX can find more information about it on the BetaShares website.

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