Covered call ETF: Strategy, benefits & how to use them
Key takeaways
Understanding covered call ETFs is key to making them work for you.
Covered call ETFs generate income through premiums on call options.
Covered call ETFs could potentially bring in more money, but they’re also more complex to navigate.
Learn how to evaluate covered call ETFs to make smart investment decisions for your own portfolio.
What Is a covered call etf?
A covered call ETF (exchange traded fund) owns stocks and collects premiums from selling call options on stock. Call options grant buyers the right to purchase the stock at a predetermined price by a set date.
How the covered call strategy works (in the ETF context)
The ETF holds underlying stocks, then sells call options on some of them. The premium received by the ETF for those call options becomes part of the income that the fund then distributes to its investors.
Why “covered call” and what the trade-offs are
A covered call means the fund owns the underlying assets and then sells call options on the owned stock. Compared to naked options — where call options are sold without actually owning the stock itself — covered calls decrease some of the risk. However, that lower risk comes with the tradeoff of not getting the full value of your stock when its price rises. That’s because the call options are capped at a certain dollar amount (the strike price).
As a simplified example, let’s say the market price of a stock rises to $100 per share, but the strike price for call options is set to $95 a share. The buyer then gets to purchase the stock from the seller at the $95 per share price, and the seller has lost out on that extra $5 of market value.
But the flip side is the fund’s investors share in the premium income that comes with selling call options.
Why investors use covered call ETFs
- Income generation & enhanced yield: Covered call ETFs generate additional income from the premiums on call options.
- Potential for lower volatility/smoother returns: The premiums brought in may reduce volatility in certain market conditions.
- Accessibility to an options strategy without individual option trading: Investors get the benefits of options contracts without having to manage everything themselves.
Key risks & trade-offs of covered call ETFs
- Limited upside potential in bull markets: Call options are capped in a covered call ETF, which means you won’t see as much return when the stock market takes off.
- Still subject to market risk: At the end of the day, this type of fund is still trading on the stock market, so there’s the inherent risk of losing money.
- Higher fees/complexity: These funds are managed by experienced investors because they’re more complex, and they generally have higher fees.
- Tax considerations & income character: Distributions from ETFs may be taxed differently. For instance, option premiums may be taxed as income or as a short-term capital gain, while gains from selling stock may be treated as a capital gain. It’s important to take tax implications into account since there variability exists in how ETF distributions are taxed.
When does a covered call ETF make sense?
Ideal market conditions & investor profile
These funds can be a good fit for people looking for a more reliable, less volatile source of investment income and the stock market is in a relatively stable to sideways condition.
When it might be less appropriate
This fund generally won’t bring in high returns during a bull market. It’s also not the best choice if you can buy the fund’s stocks on your own for a lower price than the fund offers.
How to evaluate a covered call ETF
- Underlying holdings & strategy details: Compare the fund’s holdings and strategy with your current investments to ensure your investment goals align with the fund’s.
- Yield, distribution history & reliability: Look through the fund’s yield and distribution history, noting what dividends and premiums were earned and paid out to the fund’s investors. Look for a significant history of returns to indicate reliability.
- Expense ratio & management style: Look at the net expense ratio of a fund to understand what fees you’ll pay. Those fees are used to manage the fund and are typically shown as an annual number. Also review how the fund itself is run, from how stocks are chosen to when call options are sold to how many call options are sold.
- Performance in different market scenarios: Check into how the covered call ETF did in different markets, from bearish to bullish and in between.
- Tax treatment & portfolio role: Some of the distributions in covered call ETFs are taxed as general income, which isn’t ideal for every investor. You’ll also want to consider how the fund fits into your personal investment portfolio, looking at whether it offers diversification and the right amount of risk for your tolerance level and financial goals.
Popular covered call ETFs & examples
XYLD – Global X S&P 500 Covered Call ETF
This fund owns S&P 500 stocks. Its goal is to create large income streams in a relatively stable or a down market.
QYLD – Global X Nasdaq 100 Covered Call ETF
This fund follows Nasdaq-100 stocks, mostly in tech and communications industries. Its goal is to create large income streams while remaining less volatile than if you were to own Nasdaq-100 stocks individually.
JEPI – JPMorgan Equity Premium Income ETF
This fund follows the S&P 500 while minimizing volatility and generating income as well as offering the possibility of gains.
Bottom line
Covered call ETFs can offer benefits like steady income with less volatility than trading stocks directly. These funds also come with trade-offs like limited gains and potential tax consequences, as well as potential for loss of principal. Exploring the various funds available, understanding the pros and cons of covered call ETFs, and ensuring a good fit with your investment portfolio and risk tolerance can be smart moves to make before investing.
Another option that may reduce risk and volatility exposure would be certificates of deposit (CDs), which allow you to lock in an interest rate for a set period of time.
Frequently asked questions
ow does the covered call strategy generate income?
Income, or premium, is generated when the fund sells call options on owned stocks.
Why might a covered call ETF underperform in bull markets?
Call options give the buyer the right to buy the stock at a set price. Even if the stock shoots above the strike price in a bull market, the fund must honor that price and its investors lose out on that potential gain.
Are covered call ETFs a good choice for retirees?
They may be a good option for retirees hoping to avoid high volatility while potentially receiving a steady income over a shorter period of time.
The above article is intended to provide generalized financial information designed to educate a broad segment of the public; it does not give personalized tax, investment, legal, or other business and professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other business and professional matters that affect you and/or your business.
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