SMCY Is an Income Hack on Supermicro todayheadline

Are you an income-seeking investor who also wants — or needs — growth? That’s a bit of a pickle. After all, the more you have of one, the less you typically have of the other.

There are some picks that let you have your proverbial cake and eat it too, however. While they’re not a great fit for everyone’s portfolio, option-writing-focused exchange-traded funds (ETFs) can provide ongoing dividend income in addition to offering you most of the benefits of owning stocks. There’s even a handful of single-stock-focused option-writing ETFs.

One of these ETFs worth a closer look right now is the YieldMax SMCI Option Income Strategy ETF (SMCY 0.00%), which turns something like a position in Super Micro Computer (SMCI -0.41%) into an income-generating holding.

Here’s the deal.

What the heck is option writing?

Don’t sweat it if you’re not familiar with options; plenty of veteran investors aren’t. The kinds of stock options that are bought and sold via an exchange just aren’t something most people need to bother delving into.

Still, there’s nothing wrong with understanding them. You absolutely should understand options if you’re going to consider any such income-producing exchange-traded funds — even if you’re never going to directly trade options for yourself.

In the most basic sense, an option is a bet that a particular stock or index will make a particular move within a predetermined period of time. Call options are bullish bets. Put options are bearish bets. Like any other bet, you pay to make these wagers.

Options are also legitimate securities, though, not only trading as such but priced in the familiar bid/ask auction format that allows their price to constantly change. A call option gains in value when the price of the underlying stock or index does, while a put option gains value when the underlying stock or index falls. Conversely, call options lose value when the stock or index in question falls, while put options lose ground when the index or stock at its basis gains in value.

Here’s the fun part for income-seeking investors: You don’t just have to buy options and then hope to sell them for a profit in the future. You can sell options first, pocket the proceeds, and then aim to cover these trades in the future by buying them back at a lower price. Or, better still, just let those options expire altogether, essentially exiting the trade at no cost.

That’s option writing.

There’s risk, of course. The chief risk is just that you’re forced to buy (or “cover”) these option trades at a price above your initial sale price, locking in losses. Or, in the case of the covered call strategy that YieldMax is using with its ETFs, you could be forced to hand over shares of the underlying stock that are essentially serving as collateral for your option trade. In most cases, you’d be doing so while the stock in question is rallying, meaning you’re missing out on much of that ticker’s upside. This is why option selling can be such a tricky business.

(If you still don’t fully understand the idea, it might be worth rereading the section you just completed before proceeding to the next one.)

How the YieldMax SMCI Option Income Strategy ETF works

Enter the YieldMax SMCI Option Income Strategy ETF.

Just as the name implies, the fund managers of the YieldMax SMCI Option Income Strategy ETF regularly sell call options against shares of Super Micro Computer that the fund already holds. This generates ongoing income, most of which is distributed to the fund’s owners each and every month. However, in that the fund also owns a bunch of Super Micro Computer shares, holding this fund is somewhat akin to holding a stake in the stock itself. That’s why the two investments generally move in the same direction, even if they don’t move to the same degree.

It usually works well enough. Although SMCY’s net asset value (or market price) has unsurprisingly trailed the performance of SMCI since the fund launched in September of last year, it’s also dished out $20.20 worth of per-share dividends — or distributions — during this time. That’s about twice the ETF’s current market price, almost keeping its total net return even with Super Micro Computer shares’ performance during this stretch. It just delivered about half of this performance in the form of dividend income instead of capital gains. Indeed, SMCY’s trailing-12-month dividend yield stands at just over 100%.

Data by YCharts

Just think it through, keeping the risks and downside in mind

It seems almost too good to be true. You’re getting the bulk of the net benefit of owning a great growth stock, but you’re getting a big chunk of this benefit in the form of cash. In many ways, it is a great alternative to outright owning a stake in SMCI — particularly for investors who like to constantly accumulate cash to fund new growth investments.

There are downsides and risks worth considering, though. Chief among these risks is the underlying strategy of selling or writing options itself.

Although the ETF’s managers do a great job of balancing the inherent risk and reward of options trading, there are some risks that simply can’t be managed away. In this case, the big risk is just that SMCI shares unexpectedly soar, and the fund is forced to hand over shares of Super Micro Computer in the midst of a rally. That, or the fund is forced to cover what are essentially “short” option trades by exiting these positions at a loss. Again, the call options that YieldMax is selling gain in value when SMCI rises, but that works against the strategy at work here. SMCY’s managers want the value of the options they’ve already sold to lose ground.

Sooner or later, it will happen. Even if it only happens occasionally, it can hurt the value of the fund in a hurry.

The other downside is just the cost of managing such a fund.

Unlike enormous index funds like the SPDR S&P 500 ETF Trust or the Vanguard S&P 500 ETF, the YieldMax SMCI Option Income Strategy ETF’s annual expense ratio — or management fee — is hefty, at nearly 1%. Despite what many fund companies will argue, that does take a direct toll on net performance.

Also, bear in mind that income-generating funds like this one tend to create a pretty big tax liability every year. Distributions are essentially dividends, after all.

Still, there are some scenarios where an exchange-traded fund like this one makes sense for certain investors. Growth investors who would like some of their gains in the form of ongoing income, for instance, may be interested. That’s particularly true if the position is going to be held within a tax-deferring retirement account.

The key, of course, is just figuring out whether or not the underlying stock in question is worth owning in the first place. If you don’t actually want to buy and hold Super Micro Computer, the income aspect of YieldMax SMCI Option Income Strategy ETF alone doesn’t make it more attractive enough to matter. Fellow Fool.com contributor Brett Schafer’s got something to say about that.