Selling covered calls is a classic options strategy for investors who want steady income from their investments with some protection against risk. One drawback of this strategy is the effort and capital required to buy enough shares to cover the options you sell and then sell the options. Covered call exchange-traded funds (ETFs) allow investors to buy shares in a fund that conducts this strategy on their behalf, offering its benefits with less effort.
Key Takeaways
- Covered call exchange-traded funds (ETFs) could earn investors additional income through call options, serving as a buffer against market volatility.
- While covered call ETFs can provide steady income, the strategy limits the potential upside that other ETFs might have.
- This reduced upside potential makes it less appropriate for those who foresee significant appreciation in the underlying assets.
- Covered call ETFs can be equity-based, index-based, or sector-specific, giving a range of choices for diversifying an investment portfolio.
What Is a Covered Call ETF?
A covered call ETF is an exchange-traded fund that uses covered calls to generate income.
For covered calls, the ETF purchases shares in a business and sells call options for those shares. The ETF earns a premium when selling the option and owns the underlying shares unless the option is exercised and they are sold.
A covered call strategy can generate more income through the premiums received while offering some protection against drops in the underlying asset price. The tradeoff is the limit to the ETF’s potential upside on particular stocks. If the stock rises enough, the ETF has to sell it at the option’s strike price, if exercised.
By investing in a covered call ETF, investors can avoid the manual process of buying shares, choosing a strike price, and selling options. Instead, the fund managers handle that process for you.
How Covered Call ETFs Work
Like other ETFs, covered call ETFs let investors buy shares in a single security. In exchange for a fee, called an expense ratio, investors can use ETF to diversify their portfolios.
The managers of covered call ETFs execute a covered call strategy on behalf of the fund’s investors. They buy shares in various companies and then sell call options to collect a premium.
That regular source of income helps the fund offer dividend income to investors. It can also reduce volatility in the fund’s price because decreases in the value of the fund’s holdings can be offset by the premiums that the fund earns from selling options. However, it also limits the upside. If a share rises above the call option’s strike price, it will likely be exercised and sold at the lower-than-market strike price, setting a cap on how much the fund can benefit from price appreciation in its holdings.
Advantages and Disadvantages of Covered Call ETFs
Covered call ETFs help investors use this strategy more easily, but it’s important to consider the drawbacks before investing.
Advantages
Covered call ETFs have grown more popular because they offer benefits to investors:
- Selling covered calls can help a portfolio produce income. This income can be distributed as dividends, offering a potentially higher yield than a traditional ETF.
- This premium income can help limit volatility by offsetting price drops.
- Investing in a covered call ETF could involve fewer fees and lower costs than selling options on your own.
- The cash flow from an ETF may be taxed as capital gains, offering preferential tax treatment to using this strategy on your own.
Disadvantages
Though there are many reasons to consider investing in covered call ETFs, it’s important to understand the drawbacks and risks before you do.
- Selling calls limits the upside potential if a stock price increases. If the underlying securities experience significant growth, then a regular ETF would, at that point, have higher returns.
- Like all investments, the value of the ETF could decrease, even if the premium income helps limit those losses.
- Other investments, like bonds, may offer more income than covered call ETFs.
Examples of Covered Call ETFs
Many ETFs use a covered call strategy. The largest, based on assets under management (AUM), is the Global X Nasdaq 100 Covered Call ETF (QYLD).
As of the first quarter of 2024, the fund had $7.65 billion in net assets and had offered monthly distributions to its investors for the past nine years. Since beginning in December 2013, it has had an annualized return of 7.00%.
Some ETFs focus on selling covered calls on stocks in other indexes, such as the Global X S&P 500 Covered Call ETF (XYLD) and the Global X Russell 2000 Covered Call ETF (RYLD).
Other asset managers, including J.P. Morgan and BlackRock, offer covered call ETFs, each with a particular covered call strategy. For example, the iShares 20+ Year Treasury Bond Strategy ETF (TLT.O) invests in long-term bonds.
Given the variety of funds, investors should be able to find one that matches their preferred strategy.
Do Covered Calls Outperform the Market?
As with any investing strategy, a covered call strategy may outperform, underperform, or match the market. Generally, covered calls do best in sideways or down markets. Because selling covered calls limits the upside potential, they may underperform during times when the market is rising.
What Impacts Call Premiums?
The premium you receive from selling a call depends on a few factors. Generally, the closer the strike price of the option is to in the money or profitable and the more time left until the expiration date, the higher the premium will be.
Are Covered Call ETFs Active or Passive Funds?
Fund managers have to regularly adapt the fund’s portfolio and sell options, which means that these ETFs are actively managed. Thus, they typically have a higher expense ratio than passively managed funds.
How Does a Covered Call ETF Differ from a Regular ETF for Returns?
Covered call ETFs generally aim to have income through the premiums from selling call options. Still, this strategy caps the upside potential if the underlying assets significantly appreciate. Alternatively, the revenue from premiums offers a cushion against minor declines, making it potentially less risky in certain market conditions.
Can I Use a Covered Call ETF in My Retirement Portfolio?
Yes, a covered call ETF might be suitable as part of a diversified retirement portfolio, especially if your focus is on strategies generating more income. The risk-mitigating features of these ETFs could complement more conservative investments common in retirement accounts. As with any investment, though, it’s important to consider your overall risk tolerance and investment goals.
The Bottom Line
Covered call ETFs let investors benefit from this options strategy without needing the requisite capital to either buy a large number of shares or handle selling options on their own. These funds can be a strong source of income for investors, but it’s important to understand the drawbacks, such as the limits they place on how much investors can benefit from price appreciation.
Before investing in a covered call ETF, make sure the strategy is right for you, then find a fund that matches the specific strategy you desire.
