Capital Efficiency Gone Berserk?

Ok, buckle up, this is interesting. Hat tip to Eric Balchunas for finding this ETF filing. I then found a related filing.  

The filings are under the name YieldMax. One filing is for 10 individual stock "option income" funds and 5 ETF "option income" funds. The basic strategy is not to own the underlying stock/ETF but to instead use options to create a synthetic position in the underlying stock/ETF with what if often called a risk reversal. Steve Sears writes about this strategy in the Barron's Striking Price column all the time. A risk reversal gains exposure to the underlying's upside with a long call option and the underlying's downside with a short put. 

If you don't want to go further down the option mechanics rabbit hole, skip down to the paragraph that starts There's still a lot of detail. High level, these buy calls, sell puts and sell calls.

If the price of the underlying goes up, the long call will generally track the underlying and the short put would expire worthless which is what you want to happen with a short put, you hope the put you sold expires worthless allowing you to keep the premium collected with no other action, free to then move onto the next trade. 

If the price of the underlying stock/ETF goes down then the call will drop in value, possibly expiring worthless which is not what you want when buying a call. The put that has been sold becomes a problem if the price of the underlying drops below the strike price of the put. If a put with a strike price of $50 is sold and the underlying stock/ETF drops to something like $45 then the person selling the put will have to buy that stock going for $45 in the open market at $50 per share. That sort of outcome for selling a put might be a bummer but where it gets catastrophic is if the underlying stock/ETF in this example drops to $15 in some sort of crash. The put seller would be paying $50 for a $15 stock. 

Once you digest all of that, in addition to the risk reversal, the funds will then sell a call option against the long call at a higher strike price. The long call/short call is referred to as a spread and with this type of spread, the short call basically acts as a covered call option sold against stock. So if the underlying stock/ETF goes up too much then the fund won't participate in any upside beyond the strike price of the call sold. Most of the actual assets in the YieldMax funds will be in short term treasuries with the notional shares controlled by the fund being investing in the option strategy. 

The call premium brought in from selling calls will contribute to the yield kicked out by the fund as will the put premium potentially. The treasuries can be used to buy stock put to the fund or more likely exit the put position in the face of a very bad outcome, the filing isn't clear on this point but you can think of the short puts as being cash secured. The short calls aren't naked, if the underlying stock/ETF goes far above the strike of the call, and the call is assigned, the long call can be exercised to meet the obligation of the short, assigned call option. 

There's still a lot of detail not in the filing but the above gives a decent picture of how they work so the questions then turn to how will they do, will they track the underlying stock/ETF, will they be a proxy for some other effect?

There was not much detail about how the strike prices of the various options are chosen. I would hope there's some sort of quantitative process for trying to reduce the odds of the short options being assigned but again, I found no mention of that. 

The filing is properly disclaimed about not tracking gains for the underlying so they've covered themselves but what should a prospective investor expect? My hunch is that the best environment for these would be a slow, unvolatile grind higher for the broad market, below historical, annual averages. In a year like 2021, I think they'd get left far behind. In a year like we've had this year, I have to believe some of the put options would work against the funds. 

For the single stock filing, some of the names included are Meta (META) down 51% YTD, Tesla (TSLA) down 32% YTD, Nvidia (NVDA) down 48% YTD, Coinbase (COIN) down 78% YTD and Netflix (NFLX) down 70% YTD.Those sorts of declines in just six months quite possibly would have ended those funds if they'd already been trading. If you don't think Netflix is going out of business, then selling a put on it after a 70% decline doesn't seem crazy to me. Risky yes but not reckless if cash secured. Selling a put on an individual stock isn't my trade but down 70% is a better time to do it than when it's at an all time high. 

If the YieldMax ETFs came out tomorrow, I doubt the short put would be the biggest threat now. If they came out a year ago, the short puts would be the biggest threat.

It would be great if these end up functioning like some sort of lower vol, capitally efficient version of the stocks/ETFs they track but I don't think that will be the case. Just as the covered call ETFs don't really look like the things you'd think they would track, I think the YieldMax funds will be very different looking. The way they sell volatility might not work very well, maybe the ETF YieldMax ETFs (if you're following that) will fare a little better if they are less volatile than the individual stock YieldMax ETFs.

If they come to market, I will watch them closely and if they do better than I think they will I will write a follow-up blog post on them and we can assess how they might fit in to a diversified portfolio. This was a good look at thought process in terms of my wanting to learn as much as I can about different types of products and exposure. I say this a lot, the world is evolving, markets evolve, investment products evolve. I say all the time I look at way more thing than I ever use. This is probably another of the one to look at and learn aobut but not use. 

If you want to dig in further here is the filing for the single stock YieldMax funds and for the ETF YieldMax funds. Let me know if I missed anything.