CONY: Lose-Lose Positioning, As Crypto Market Appears Likely To Soar Or Crash

seekingalpha06-27

Call-option-oriented ETFs may not be suitable for generating sustainable and predictable income because premiums decline with stock prices and are capital returns, not dividends.CONY's strategy does ...

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CONY's positioning is ill-suited in either case, whereas long options may be better in current market conditions.   Phira PhonruewiangphingThose who follow my work may know I am generally critical of call-option-oriented ETFs, such as those managed by YieldMax and others. This is not because these funds lack efficacy or that there is an issuer with the manager, but that investors often misunderstand the dividend income potential of this strategy. Put simply, I believe selling calls is not a viable way to produce sustainable and predictable income. Further, doing so on highly volatile stocks is likely to deliver poor risk-adjusted returns in the long term compared to owning such stocks outright. That said, selling calls can be a speculative strategy that will outperform over specific periods, making them viable for those with specific speculative or technical outlooks. However, I think they're very unsuitable as an income strategy for retired investors.  The ETF (NYSEARCA:CONY), which focuses on covered calls on Coinbase (COIN), is perhaps among the more risky covered call funds I've encountered. The primary issue is that COIN is often prone to extensive and prolonged periods of positive or negative trends and is rarely in a range-bound environment that would lead to covered call outperformance. Thus, CONY is more likely to deliver lackluster returns than its underlying asset. Still, this depends significantly on the performance of Bitcoin and other cryptocurrencies. Investors may significantly underestimate CONY's risks since the cryptocurrency market has been generally strong over the past two years.  Why CONY Will Usually Underperform Firstly, CONY's more accurate SEC dividend yield is 4.73%, not 83.7%, as it may seem based on its TTM distribution. A distribution and a dividend are not the same, though they are too often conflated. A distribution includes both true dividends and returns of capital. In CONY's case, its dividend comes from its Treasury bond positions, while its capital returns (making up most of its distribution) come from call option premiums. This is important not just for tax purposes but also because an option premium does not carry the same attributes as a dividend. Option premiums are positively associated with volatility, meaning CONY's distribution yield usually rises with COIN's volatility. However, option premiums are also directly proportional to share prices, so if COIN loses value, which is often the case when its volatility increases, we will eventually see a sustained decline in CONY's distribution rate as premiums decline proportionally to stock prices.  I think many investors and analysts are often mixed up at this latter point. For example, in stocks and bonds, it is usually that their dividends/payments will not decline even if their price does. A large decline in a stock's price may result in a temporary (or permanent) dividend cut, but that stems from a decrease in profitability, not a direct result of lower equity prices.  Further, a large increase in equity prices will not necessarily improve the distribution rate because covered call selling results in capped appreciation but unlimited downside (to zero). That said, this depends significantly on the specific strategy YieldMax decides to pursue. It is actively managed, so it can use many different option strategies to try to earn the best return. This approach makes its distribution and risks less predictable but may make CONY more adaptable to market conditions.  Using a live option pricing tool, I modeled the risk-return profile of its current holdings. Today, it has a written (negative) put position at 260, expiring July 19th, and a 260 positive call position expiring the same date. Together, these options create a \"synthetic long,\" akin to a normal bullish position but with far less capital needs. It also has a written June 28th call at 222.5, which is about at-the-money, and an additional written June 28th call at 237.5, which is out of the money. Together, these provide CONY with a slight premium if COIN stays where it is and some added appreciation potential if COIN rises markedly. It is essential to consider I'm looking at this very close to the expiry date. I've modeled these positions proportional to their market value per CONY's holdings for 6/26. From this modeling, the fund would have a ~$5M gain (~80 bps on $614M in underlying assets) given no change in COIN and a maximal gain of $43M (7% on underlying) should COIN surge by 8% in the coming days to ~$237. Thus, we see a nearly linear correlation in likely appreciation, with potentially negative exposure past that $237 mark, making this strategy far from the typical covered call. See below: Estimated COIN Option Payoff for CONY 6/26/24 (OptionsProfitCalculator)To be fair, I think this is a good strategy for COIN today. It provides a small but material potential return given no change in COIN's value, with nearly linear appreciation potential up to a normal probable increase in COIN and negative exposure past the point of an unlikely rise in value. The latter is the tradeoff of having the small benefit of a gain given no increase in COIN's value.  Crucially, CONY can alter its strategy at any time. It will likely do so, so my modeling will not necessarily be accurate as it rolls its strategy forward once these options expire. However, I think it is fair to assume that CONY's managers are pursuing a covered-call-like strategy, altered specifically to improve appreciation potential. For a typical \"at the money\" covered call strategy, we'd expect a more significant potential gain given no change in the underlying value, offset by a lower \"cap.\" This implies CONY's managers do not want the fund to underperform significantly in a bull market, as is typical of covered call strategies.  Still, CONY does considerably underperform during COIN's bullish rallies. We can see this by comparing the charts below. First, see the total return (which includes reinvested distributions) and price return ratios of CONY to COIN since CONY's inception: Data by YChartsThe lower chart shows how CONY will consistently depreciate compared to COIN, with slight variation over time. That is simply because option strategies require continued full distribution reinvestment to maintain their value. If investors treat CONY as \"income\" by taking these capital distributions out, they will eventually lose all of their capital investment. It may take many years and will not occur during bull markets, but it is inevitable that most typical call-selling strategies will cause capital decay toward zero simply because the downside is not capped while appreciation is. Hence, option premiums are capital returns, akin to selling a portion of your assets for cash (\"taking money from the piggy bank\"), but not a cash return on invested capital. Those interested in CONY as a personal income strategy should consider it more akin to a reverse mortgage because these distributions ultimately come at the expense of equity.  Still, if all distributions are reinvested (total return), we can more accurately see how the overall performance of COIN and CONY differs. Theoretically, the long-term difference should not be huge if we assume the option market is fairly valued. CONY's underperformance on a total return basis can be attributable to its lower volatility, stemming from its slight protection against downside risk (from having positive premium returns even with stagnation in COIN). The total return ratio chart demonstrates that CONY underperforms COIN during its bull markets but outperforms during stagnation and consolidation. CONY's most considerable underperformance periods are in November and December 2023 and February and March of this year. This coincides with the significant increases in COIN's value, which Bitcoin and others primarily drive. See below: Data by YChartsThese rallies are associated with an increase in volatility. For the most part, higher volatility equals higher potential premium returns on calls but a greater risk of loss. As such, a significant volatility spike followed by a stagnant consolidation period benefits CONY during the latter, as that will usually be where premiums are the highest compared to actual volatility. Of course, we can only see that in retrospect. It is very hard to predict where a trend will end, but if you can, selling options at such levels will usually have the best risk-reward potential. Conversely, we can see CONY underperforms during positive trends, meaning it should not benefit greatly from a \"to the moon\" event in cryptocurrencies. Further, going back to my P&L model for CONY, we can see its potential for losses in a bear market is not significantly mitigated. It is often said that covered calls have protection against downside risk. That is, to me, inaccurate, as long put options are means by which downside risk can be limited. For example, if COIN is flat for a month, we should expect CONY to earn a 1-5% added premium return. If COIN crashes, theoretically losing 50% of its value in a month (which it has historically), then CONY should lose that amount minus that 1-5% premium return, so in this case, 45-49%. Again, that is theoretical as its specific strategy could differ, but it is generally true based on its current holdings. In short, CONY's strategy does not offer protection against downside risk but a small return regardless of COIN's performance, giving a slight offset to a large decline. However, investors should understand this as a minor benefit during stagnant periods, with very slight mitigation against large declines. Realistically, if COIN crashes as it did from 2021 to 2022, CONY would see very similar losses, with perhaps a few percent in added relative performance.  The Bottom Line CONY's performance is driven by COIN, which Bitcoin drives. As of May, I have a bearish outlook on COIN, as described in detail in \"Coinbase: Cryptocurrencies Moving From 'New Paradigm' To Denial (Rating Downgrade).\" It is worth noting that I had a bullish view on COIN from January of 2023 to the end of the year, taking advantage of the 300% gain over that period. I am now bearish on COIN. I think it is overvalued as a company compared to its potential earnings, and I feel that the crypto bull market is reaching its peak. I also believe Bitcoin's efficacy as a currency is greatly overestimated, although that is a long-term factor. In the short run, I would not be surprised to see Bitcoin reach $100K, which would be bullish for CONY and COIN. That said, it seems more likely that its momentum is too low for that to occur. A blow-off-top in Bitcoin would benefit it and COIN, but not necessarily for CONY because its appreciation potential is capped. Thus, I am particularly bearish on CONY today because I think it will either face significant losses from a COIN reversal crash or stagnate as COIN continues to rocket up. To me, CONY currently has a \"lose-lose\" positioning since I think it is unlikely Bitcoin or COIN will enter a prolonged range (or stagnation), which would advantage CONY. COIN's current implied volatility is 62%, which is much below its normal level. As such, it may be best to buy options (either calls or puts, depending on directional views) rather than sell them, assuming COIN is due to another volatility spike. Personally, I think a long straddle or strangle (specifically) could be best today, which is essentially the opposite of CONY's current positioning.   CONY also has a higher 1% expense ratio and is not entitled to dividends from COIN. It is unlikely COIN will pay large dividends anytime soon, but that largely stems from CONY using a synthetic long position rather than a standard long position. CONY's expense ratio is higher than most but is not atypical of an actively managed fund. Still, it adds to the reasons why it is likely best to speculate on COIN or cryptocurrencies instead of CONY. 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