Covered call strategies were once the exclusive province of sophisticated options traders. However, exchange-traded funds (ETFs) give investors of all stripes access to them with covered call ETFs. A covered call ETF can boost investor income by writing call options on the stocks held by the ETF. They can also reduce investment risk and allow investors to take advantage of upside potential in the same way options do. Two popular covered call ETFs are the Global X S&P 500 Covered Call ETF (XYLD) and the Global X Nasdaq 100 Covered Call ETF (QYLD).
Covered calls are an excellent form of insurance against potential trouble in the markets. When an investor with a long position in a particular asset sells a call option for that asset, generating a profit in the process, it is considered a covered call. A key to the covered call approach is that the call option buyer is obligated to pay a premium to buy it. That means smaller losses if the asset declines in value. The seller also can benefit if it goes up in price, provided the calls were out of the money.
Key Takeaways
- According to a study commissioned by the Cboe, a strategy of buying the S&P 500 and selling at-the-money covered calls slightly outperformed the S&P 500.
- Partly due to the increase in returns when market volatility is high, a covered call approach is usually considerably less volatile than the market itself.
- A covered call ETF will also perform quite differently than the S&P 500 during particular years.
- Covered call ETFs make a relatively complicated and fairly profitable options market strategy easily accessible to average investors.
Potential for Higher Returns
There’s been a number of studies that analyze the strategy of selling covered calls. however, whether or not the strategy results in higher profits may be decided by broader economic factors. For example, a study commissioned by the Cboe showed an 830% return to the at-the-money covered calls strategy between June 30, 1986, and Dec. 31, 2011. During that same period, the S&P 500 went up 807%. However, a study by FTPortfolios found the covered call strategy outperformed the S&P Index just four years between 2003 and 2021.
The key to the strategy’s success is that the value of covered calls on the S&P 500 goes up when volatility, as measured by the VIX, goes up. The VIX is also known as the fear index because it tends to rise when the fear of losses is higher. When one considers what a call option does, it is only natural that their value would go up when anxiety is high. A call option allows the buyer to get all the gains of a security with none of the downside risk during a specified time.
Since perceived risk and real rewards tend to be correlated, the call option buyer’s low risk results in fairly low returns in the long run. The call option seller, who takes a high risk of loss with limited potential for gain in any given month, turns out to do much better in the long run.
Guarding Against Volatility
Partly due to the increase in returns when market volatility is high, a covered call approach is usually considerably less volatile than the market itself. Over a long time frame, the strategy of buying the S&P 500 and writing at-the-money calls had between 30% to 40% less volatility than the S&P 500 itself. This figure is derived from a 2012 volatility study and 2019 volatility study, both by CBOE.
Particularly in an unstable political climate, covered call ETFs can be a good way to ride out riskier periods in the market while still bringing in a profit.
According to Jonathan Molchan, former portfolio manager and head of product development for Global X Nasdaq 100 Covered Call ETF (QYLD): “When volatility goes up, people typically get a little concerned. But a covered call will exhibit less volatility than the broader market.” Molchan could point to his own ETF as an example of this effect. QYLD sells a monthly, at-the-money covered call on the Nasdaq 100. The income the ETF generates goes up when investors’ fears concerning the index rise.
For investors in QYLD, this creates at least two benefits. First, according to Molchan, “their monthly dividend will increase,” and second, “the premium received on that monthly covered-call strategy also serves as a measure of downside protection, for when the market does sell off.” A covered call ETF like QYLD creates income from market volatility.
A Different Pattern of Returns
A covered call ETF will also perform quite differently than the S&P 500 during particular years. As a general rule, these ETFs will tend to lag in bullish years when the market advances slowly and consistently. In bearish years when fear and volatility are high, the large premiums earned from selling covered calls help to reduce losses.
Covered calls can also produce respectable returns right after a market crash, when volatility levels usually remain elevated. The fact that covered-call strategies typically have lower volatility and similar returns to the S&P 500 means they often have better risk-adjusted returns.
A covered call ETF can be a good alternative to giving up on the stock market when bearish sentiment is high.
ETF Simplification of Covered Calls
Covered calls are relatively straightforward, but they are nonetheless more complicated than many popular investing strategies. Unfortunately, many investors might be too intimidated to explore the possibilities available to them through covered calls in the options market.
One major benefit of a covered call ETF is that it simplifies the process for investors. An ETF like QYLD uses Nasdaq 100 Index options, which can’t be exercised early.
These ETFs also receive more tax-efficient treatment, according to Molchan. All of this is to say that covered call ETFs take a lot of the detailed work of investing in this area out of the individual investor’s hands and place it under the care of the ETF management team.
How Do Covered Call ETFs Generate Income for Investors?
Covered call ETFs generate income through the sale of call options on the securities held within their portfolios. When an investor purchases a call option, they pay a premium for the right to buy the underlying asset at a predetermined price within a specified time frame. By writing (selling) call options, the ETF collects these premiums, thereby generating income for investors.
What Are the Risks Associated with Investing in Covered Call ETFs?
One primary risk is the potential opportunity cost, as the strategy may limit the ETF’s participation in significant market upswings. Another risk is that if the market experiences a sharp and sustained decline, the downside protection provided by the covered call strategy may not fully offset losses.
Are There Tax Implications Investors Should Consider with Covered Call ETFs?
While the income generated from writing call options is typically treated as ordinary income, the specific tax treatment may vary based on individual circumstances and tax regulations. Taxpayers may also experience capital gains or losses depending on the timing of a sale of ETFs along with the vehicle in which the ETF was held.
How Liquid Are Covered Call ETFs, and What Is the Ease of Trading?
Covered call ETFs, like other exchange-traded funds, are generally liquid and trade on major stock exchanges. The ease of trading depends on factors such as the fund’s average daily trading volume, bid-ask spreads, and market conditions.
The Bottom Line
Covered call ETFs employ a strategy of selling call options on underlying securities to generate consistent income for investors. Compared to other types of investments, investors may generate a unique combination of income and downside protection. These funds offer reduced volatility, enhanced yield, and the potential for conservative growth.