24th May 2024
Seek Current Income with Defiance’s Put-Write Enhanced Options Income ETFs
QQQY, WDTE, IWMY
Selling short dated options can generate outsized daily premium.
On a daily basis, these options are more expensive than longer term options. By selling them, this creates opportunities to generate current income and reduce daily risk.
What’s the key to generating current daily income?
It’s called “time value” (also known as extrinsic value). Defiance ETFs, LLC, a creator of ETFs for the next generation, has partnered with ZEGA Financial to capture that time value each day and distribute it to investors.
The strategy, forged from over 100 years of options trading experience, also allows the ETF investor to participate in market gains should the underlying index rise on a given day.
Defiance Enhanced Options Income ETFs come in three versions, each trading on a specific index:
Nasdaq 100 (NYSE symbol: QQQY)
S&P 500 (NYSE symbol: WDTE)
Russell 2000 (NYSE symbol: IWMY)
How it works
Every trading day, each of these three ETFs sells a daily in-the-money (ITM) put option on the ETF’s target index.
Typically, selling a put option means you are selling the right for the buyer to “put” the stock to you at the strike price of the option. When the option is in the money, this means the market price of the underlying (e.g. S&P 500) currently trades below the strike price of the option. The Defiance ETF sells the index option at a price (known as the premium) that consists of the difference between the strike price and the current index price; plus the time value. The time value will always decay to zero when the option expires.
But this time value only decays for the buyer. The ETF, as seller, keeps the initial time value which is then later distributed to the ETF’s investors.
The intrinsic value portion of the ITM put that has been sold is what provides investors with market exposure. Here’s how it works.
In this first example, the underlying index has risen in price and is higher than when the option was sold. (Of course the option strike price always remains the same.)
The intrinsic value has shrunk and the option is worthless. In the cash settlement at expiration, the ETF keeps this market-related gain which is reflected in the value of the ETF.
If the market ends above the strike price, the gain is capped. (Maximum gain = initial option value)
The reverse is true when the price of the underlying index is lower at expiration.
In the foregoing graphic, the index price has dropped and the intrinsic value has grown meaning the ETF will suffer a loss in value on the day commensurate with the drop in the price ofthe index
Seeking Lower Daily Risk With Current Income
Investors in the ETF keep the time value portion of the premium which reduces the daily price decline compared to just owning the index. This reduces the daily downside volatility.
This offset means on down days in the underlying index the Defiance Enhanced Options Income ETFs should have losses reduced that day by the amount of the time premium received. The Funds’ strategies are subject to all potential losses if the indexes lose value, which may not be offset by income received by the Funds.
To summarize: every trading day the ETF:
- Sells an ITM put option on the relevant index
- Captures the time value for distribution to investors
- Sustains a gain or loss in fund value dependent on the price movement of the index
Funds invested in a Defiance Enhanced Options Income ETF overlay the short option on short-term U.S. Treasury Bills and notes accruing interest – currently a better return than the dividends paid by the stocks in the index. These positions serve as collateral for the option trades.
The daily index options are European style option so they can only be exercised at expiration. Since the options settle in cash, the ETF will never be forced to purchase the index. The ETF never actually holds shares in the index on which it trades daily options.
What to expect
Monthly distributions: that’s what to expect. As the name implies, these Defiance ETFs are built to provide enhanced options income. Each month, the cash earned from the sale of time value in daily options is distributed to investors in the ETF.
The higher the volatility the higher the time value earned from the sale of the ITM put option that can be passed on to investors.
In terms of price movement, if the value of the underlying index falls, the value of the ETF will, too.
If the price of the underlying index rises, the value of the ETF will, too. Only this increase in value – on a daily basis –is capped by the strike price of the option.
Does the NAV Decay?
If the index (i.e. SPX) moves lower, the total value will drop but that is the risk an investor takes, much like owning the index.
When the funds pay out dividends, the NAV goes down by the amount of the dividend on the ex-date like all ETFs.
By reinvesting those distributions back into additional shares, the share count goes up, but the total value remains the same even though the NAV was reduced by the dividend amount.
In the following chart for WDTE (inception through Q4 2023), it shows the difference between the price only return and the total return assuming dividend reinvestment. How the price only return is negative but when adjusting for dividends, the total return is positive.
Looking at price alone doesn’t tell the whole story.
Those distributions go somewhere and need to be included in a proper evaluation of the performance of the funds.
Choosing between…
Each of these ETFs follows the same daily option trading strategy offering exposure to the big three indexes.
Choosing between the three ETFs then comes down to two factors: your specific market expectations and how aggressive you want to be. The latter factor takes into consideration your risk tolerance – the higher the volatility the higher the distribution rate, but also the higher risk of loss in the value of the ETF.
All three ETFs are well-suited for retirement accounts as the strategy involves no margin investing.
Distributions from the ETFs include the following estimated return of capital per the 4/4/2024 19-a1 Notice: Defiance Nasdaq 100 Enhanced Options Income ETF, ticker QQQY 77.60%; Defiance S&P 500 Enhanced Options Income ETF, ticker WDTE 46.31%; Defiance R2000 Enhanced Options Income ETF, ticker IWMY 26.62%;