What Is an Option Income Fund?
Option income funds, also known as option income closed-end funds (OI-CEFs), are a type of pooled investment that aims to create current income for its owners by receiving premiums from selling options contracts.
Option income can be created by selling delta-neutral options techniques like straddles or strangles, writing covered calls, or employing other more complicated tactics.
IMPORTANT TAKEAWAYS
- An option income fund is a closed-end pooled investment that earns money by selling (writing) options contracts to investors.
- A lower-risk option income fund will often use tactics that can create consistent income streams while minimizing market exposure.
- These investments are especially effective in tax-exempt accounts such as Roth IRAs because they generate regular income streams.
Option Income Funds: A Basic Overview
Because the profits earned on the options sold are taxed as regular income rather than dividends, option income funds are typically best suited for tax-advantaged accounts.
Selling delta-neutral options methods, which do not fluctuate in value as the market moves up or down, is one way for these funds to make money. A short straddle strategy involves selling both a call and a put option with the same strike price and expiration date.
Instead of using calls and puts at different strike prices, a strangle utilizes calls and puts at different strike prices. When a trader believes the underlying asset will not move much higher or lower during the life of the options contracts, he or she will adopt this strategy. The amount of premium earned by writing options yields the most profit. However, if the market swings dramatically, the potential loss can be limitless, making this a method reserved for highly experienced traders.
Another popular approach is to sell an upside call against an existing long position in the same underlying. When adopting a covered call strategy, the portfolio might still lose money if the underlying asset’s price declines, and the maximum profit potential is also limited. A covered call strategy, on the other hand, can be a reasonably low-risk income producer if the asset’s price stays relatively stable.
Option income funds have obvious benefits, such as better returns than ordinary funds. However, rather than merely investing in dividend-paying equities, such an income-generating approach can be significantly riskier. There are various additional risks because they use options contracts.
The Benefits of Option Income Funds
In contrast, according to a 2012 article in Kiplinger, “Option-Income CEFs May Be a Smarter Choice.”
According to Jeffrey R. Kosnett, there are around 30 option-income CEFs, which range from funds that focus on simply the Dow Jones industrials’ 30 equities to funds that sell options on emerging-markets stocks. He outlined the following important benefits of such funds: “Option-income CEFs have two advantages, regardless of their strategy. To begin with, each trade at a discount to its net asset value per share. Second, these funds are suited for a market that is trapped in a tight trading range.”
“A call option gives its holder the right to buy, or call, a stock from the option’s seller at a specific price by a certain date,” according to Kosnett. Purchasing options entails a significant amount of risk. However, selling a call against a stock you already own is a safe bet. You limit the potential appreciation of your equities while generating additional money from the option sales. When you sell calls against such strong blue chips, you get not only option income but also a consistent supply of dividends. (This isn’t to argue that they are buy-and-hold funds; option-income funds will suffer as well if the stock market falls.)
Many payments from option-income funds are labelled “return of capital,” implying that you’re not getting a legitimate dividend. But, just as there are good and bad cholesterol, there are excellent and terrible financial returns. The cash inflows from option sales are predictable and long-term. So, unless an options-based fund is mishandled, it shouldn’t experience the long-term NAV erosion that plagued CEFs that liquidate assets on a regular basis to sustain large dividends.
Examining the data in shareholder reports is a useful approach to tell if an options-selling CEF is safe to invest in. Compare the “net rise in net assets from operations” with total cash distributions, according to options expert Greg Pugh. “That will give you a strong feel for the distribution’s sustainability,” he says, if the increase in net assets exceeds or only slightly trails the dividend.
For example, counting profits from selling options, Eaton Vance Enhanced Equity Income II (symbol EOS) distributed $6 million more than its assets grew in 2010. If the fund’s net asset value continues to decline, the fund’s net asset value will eventually be impacted. However, in the first half of 2011, the fund’s asset growth outpaced its payouts by $3.3 million, requiring the fund to tap into its reserves only once in 18 months to cover the $95 million in distributions. Such a tiny loss is acceptable in a fund of this size (assets total $578 million). On NAV, the fund yields 9.3 percent based on the previous year’s payouts. Because the shares trade at a 13 percent discount to NAV at $10, the share price yield is a healthy 10.6 percent (prices are as of January 6).