NVDY: 23% Yield At The Expense Of Capped Exposure To NVIDIA (NYSEARCA:NVDY)

YieldMax NVDA Option Income Strategy ETF (NYSEARCA:NVDY) is one of the classical YieldMax ETFs, which seeks to capture a part of the risk and return characteristics that are associated with very popular and liquid S&P 500 names.

In NVDY’s case, as the name of the ticker already implies, the underlying is NVIDIA Corporation (NVDA).

The Fund’s key investment objective is to achieve high streams of current income through a synthetic covered call strategy. The secondary objective is to replicate the performance of NVDA as far as the limit stemming from the option strategy allows.

Since NVDY applies a synthetic covered call strategy, we have to clearly highlight the key implications (differences from NVDA) in the risk and return profile that do not match those of NVDA.

To do so, let’s first understand the mechanics of this particular option strategy:

• First, a synthetic long exposure is created through the use of exchange-traded options – i.e., buying a call option and, simultaneously, selling a put option on NVDA with generally 6-12 month terms, and a strike that is very close to the current share price level of NVDA. The combination of the long call option and the written put option results in an exposure that performs very similarly to NVDA. So far, there are no bull or bear biases towards the particular underlying.
• Second, once the synthetic long is constructed, NVDY introduces a covered call aspect, where call options are sold against the underlying NVDA. According to the information in the prospectus, these call options will generally carry an expiration of a maximum of one month and a strike price that is in most cases 5%-15% above the strike at which synthetic longs were created. As a result of this step, NVDY introduces a limit on the potential gain that could be captured from the underlying exposure to NVDA.
• Third, since all the aforementioned positions are structured without having direct ownership in NVDA, the fund is required to hold liquid U.S. Treasuries as collateral against which option transactions could be accommodated.

So, considering the above, the main difference between NVDY and NVDA is that the fund carries an embedded cap on the maximum gains that could be captured while receiving additional compensation for this in the form of sold option premiums.

Then on top of this, there is a huge difference between how total returns are achieved. In NVDY’s case, most of the returns are explained by dividend income (which to a large extent is supported by sold option premiums), while for NVDA the key driver is obviously the price appreciation component.

Thesis

Now, once we have established how NVDY works, let me elaborate on my thinking about NVDY as an investment.

Since the inception of NVDY, the Fund has performed well, albeit clearly underperformed the underlying (i.e., NVDA). In fact, the underperformance (on a total return basis) has been rather massive, roughly 30%.

The key driver of this lagging performance has been the inherent limit of capital gains that stems from the short call option positions, which as stated above, do not allow it to participate in the share price gains beyond the stipulated strike levels.

While there are premiums coming from these written calls, they tend to play a relatively minor role in the case of rallying markets (or in this case rallying NVDA).

What is rather interesting is when we take a look at some moments of dropping results, NVDY has actually managed to do a bit better due to the pocketed premiums. However, the spread between NVDY and NVDA charts is evidently very narrow, confirming that the covered calls do not play a major role in the overall equation.

Moreover, the chart above also highlights the inherent drawback of NVDY, where under situations of heavy bounce backs or price surges, the fund tends to respond in a muted manner.

So far, I do not see any meaningful benefit of holding NVDY. With that being said there could be two instances when taking a long position in the fund could make sense:

1. Under conditions in which the market (or in this case NVDA) trades sideways for a relatively long period of time as during that moment the collected premiums would actually be material in the context of limited returns that are either slightly negative or positive. Here, in my opinion, this kind of situation where NVDA trades sideways is extremely unlikely especially given that it is classified as a pure play growth stock and is a significant part of major passive equity indices, which, per definition, inject additional volatility.
2. When particular investors want to create exposure to NVDA and at the same time still receive returns in the form of current income. Considering NVDA yields 0.03%, dividend or yield-seeking investors would potentially have an issue here. So, the fact that NVDY currently offers ~23% dividend yield and distributes it on a monthly basis, while still maintaining some exposure to the NVDA factors, the fund could be an optimal solution.

The bottom line

NVDY is an interesting vehicle, which fits nicely into investor portfolios, who believe that NVDA will deliver relatively neutral results or who want to gain exposure to NVDA but are also willing to sacrifice a part of the potential upside in order to be rewarded via dividends.

In my humble opinion, it is highly unlikely that NVDA will trade sideways given the historically exhibited volatility levels of NVDA. The stock will most likely move in notable steps either to the upside or downside. In the former case, NVDY would significantly reduce the potential gain, while in the latter case, the added benefit (i.e., protection) from call premiums would be extremely insignificant as the history of declining momentum has already proved.

The only reasonable justification for holding NVDY would be the dividend aspect, which, at least in my case, is not that critical, especially if it implies sacrificing the return potential from an inherently volatile and risky position.