Investors are increasingly using covered call strategies and ETFs as a strategy to make money in current market conditions. One of these methods is to sell call options on a stock or ETF, which can bring in money through option premiums. Investors looking to increase their income may find it appealing, as many covered call strategies and ETFs now offer 10–12% yields. In this article, we will discuss covered call techniques, ETFs, their advantages and disadvantages, and how investors can utilize them to make money in the current market.
What Is A Covered Call ETF?
A covered call ETF is a fund that purchases a selection of stocks and writes call options on them to boost investors’ yield.
Investors can profit from covered calls by purchasing a covered call ETF, which allows them to participate indirectly in the options market. The covered calls are handled for them by the fund.
The ETF-covered call strategy often entails writing short-term (less than two-month expiry) calls that are out-of-the-money (OTM), which means that the security price is less than the strike price of a call option. Investors can benefit from quick time decay by using shorter-term options.
These options also help find a balance between getting significant premium payments and making it more likely that the contracts will end up worthless.
How Do Covered Call ETFs Work?
Covered call ETFs are ETFs that produce income through the use of a covered call strategy. The covered call strategy involves selling call options on a stock or ETF, which is a well-liked way to generate income. A call option is a contract that grants the holder the right but not the duty to purchase a specific stock or ETF at a specific price within a specific time frame. The ETF can make money by selling call options in order to receive option premiums.
To distribute dividends to shareholders, the ETF uses the revenue from the sale of call options. The ETF manager will frequently choose a portfolio of stocks or other assets and sell call options on those assets. The approach is called “covered” because the ETF holds the underlying assets and can be delivered if the options are exercised.
Covered call ETFs tend to have less volatility than other ETFs because the goal of the strategy is to generate income rather than capital gains. The ETFs frequently employ a technique of selling call options with a strike price only a little bit higher than the current market value of the underlying assets. In this way, the ETF can make money without giving up a big chunk of the possible gain in the assets it is based on.
Covered call ETFs might not offer as much downside protection as regular stock ETFs because the underlying assets can still lose value. Additionally, the performance of the underlying securities and the fluctuation of the options market both have an impact on the income received from selling call options. For investors searching for a less hazardous approach to making money in the low-interest rate climate of today, covered call ETFs can offer a constant source of income.
Benefits of Covered Call ETFs
Higher Potential Returns
Buying the S&P 500 and selling at-the-money covered calls has some history of being able to outperform the S&P 500 over long periods of time. Between June 30, 1986, and December 31, 2011, there was an 830 percent return on the at-the-money covered call approach. The S&P 500 increased by 807% over the same time.
The fact that covered calls on the S&P 500 increase in value when volatility occurs are essential to the strategy’s success. When one thinks about what a call option does, it makes sense that its value would rise in an apprehensive environment. With a call option, the buyer can get all the security benefits for a specific time without taking on any downside risk.
Protection From Volatility
A covered call strategy is typically far less volatile than the markets themselves, partly because of the rise in returns during periods of severe market volatility. The long-term volatility of the buy/write at-the-money call strategy was around 30% lower than that of the S&P 500 alone.
Covered call ETFs can be a great strategy to ride out riskier market times while still making money, especially in an unstable political environment.
On the Nasdaq 100, QYLD invests in monthly at-the-money covered calls. When investors’ concerns about the index increase, the ETF’s income increases since, in theory, the cost of options should rise. There are at least two advantages for QYLD investors as a result. First, their monthly dividend income will rise and, second, the premium obtained on that monthly covered-call approach also acts as a measure of downside risk mitigation for when the market does fall off.
A Different Pattern of Returns
Additionally, compared to the S&P 500 in specific years, a covered call ETF will perform very differently. Generally speaking, these ETFs will lag in positive years when the market grows steadily and slowly. The vast premiums you get from selling covered calls help make up for some losses in bad years when there is a lot of fear and volatility.
In the immediate aftermath of a market fall, when volatility levels are typically still high, covered calls can also deliver good gains. Covered-call strategies often have better risk-adjusted returns than the S&P 500 because they are typically less volatile.
ETF Simplification of Covered Calls
Although covered calls are straightforward, they are nevertheless more intricate than many standard investing techniques. Unfortunately, many investors may need more time to investigate the options market opportunities that covered calls provide.
Investor convenience is one of the main advantages of a covered call ETF. Nasdaq 100 index options, like those used by QYLD, cannot be exercised early.
How Can Higher Volatility Be A Bonus For Income Seekers?
Higher option premiums in a covered call ETF can result from more volatile underlying assets, which can be advantageous for income seekers. Options become more expensive and valuable to sell when high volatility makes them more expensive to buy. As a result, during periods of extreme volatility, the ETF can generate a potentially higher yield from the sale of call options.
Consider an ETF that trades call options with a $100 strike price and manages a portfolio of stocks. The option premium is a few cents per share if the stock is trading at $90 right now and there is little volatility. However, if volatility is significant but the stock price is still $90, the options premium may be several dollars per share. This is good for people who want to make money because the ETF can make a much bigger profit by selling call options.
Although more volatility might result in higher option premiums, it also raises the chance of losses in the underlying assets. High volatility may result in a loss of value for the underlying assets, negating the advantages of more significant option premiums. When choosing a covered call ETF, investors should think carefully about total returns as well.
Examples of Covered Call ETFs
Global X Russell 2000 Covered Call ETF (RYLD)
RYLD is an ETF that generates income through the use of a covered call strategy. The Russell 2000 index, a widely used benchmark that gauges the performance of smaller companies in the US, serves as the foundation for the ETF.
The ETF employs a technique of selling call options on the Russell 2000 index’s underlying stocks. If the options are exercised, the ETF, which owns the underlying stocks, can deliver the stocks. The ETF can make money in option premiums by selling call options.
Due to the strategy’s focus on generating income rather than capital gains, RYLD exhibits very low volatility when compared to other ETFs. RYLD has a 13.48% dividend yield and paid $2.54 per share last year. The most recent ex-dividend date was December 29, 2022, and the dividend is paid each month.
Since the value of the underlying assets can still decrease, RYLD might not offer as much downside protection as conventional stock ETFs. But in the low-interest rate market of today, RYLD can give investors a steady income stream if they want a less risky way to make money.
Conservative investors who want to make money while less vulnerable to market volatility may consider RYLD. These investors are willing to accept a lower possible return in exchange for a lower potential risk.
Global X NASDAQ 100 Covered Call ETF (QYLD)
QYLD is an ETF that generates income by using a covered call strategy. The ETF is based on the NASDAQ 100 index, a well-known benchmark that gauges the performance of the biggest and busiest companies listed on the NASDAQ Stock Exchange.
The ETF employs a strategy that sells call options on the stocks that make up the NASDAQ 100 index. The fact that the ETF owns the underlying stocks enables it to deliver the stocks if the options are exercised. The ETF can make money by selling call options and receiving the option premiums as payment.
As with RYLD, QYLD has a low level of volatility compared to other ETFs because its strategy is based on making income rather than capital gains. With a dividend yield of 13.21%, QYLD recently paid $2.19 per share. The most recent ex-dividend date for the dividend was December 29, 2022, which is paid monthly.
QYLD is a good choice for conservative investors who want to make money while minimizing their exposure to market volatility and are willing to accept a smaller potential return in exchange for a lower potential risk.
Drawbacks of Covered Call ETFs
Investing in covered call ETFs has several disadvantages, including:
Upside Potential Is Limited
ETFs use of selling call options to generate income restricts the possibility of capital growth. This may be a drawback for investors hoping for potential growth in their investments.
Limited Downside Protection
The fact that covered call ETFs might not offer much downside protection as conventional stock ETFs is another disadvantage of these funds. Even if the ETF is making money by selling call options, the value of the underlying assets could still decrease.
Dependent on Volatility
Call option sellers can earn a profit depending on how volatile the underlying assets are. Because option premiums will be low in a low-volatility environment, the ETF will earn less money.
Bottom Line
In today’s low-interest-rate environment, covered call techniques and ETFs are becoming increasingly popular with investors to produce income. These techniques entail selling call options on a stock or ETF, which can result in option premiums being paid out as income. Investors should be aware that covered call ETFs come with their own set of disadvantages. They are complex, restricted in diversity, dependent on volatility, have limited upside potential, little protection from the downside, depending on market conditions, and are sensitive to tax issues. Investors should always keep their portfolios balanced and know all an investment’s risks and benefits before making a choice.
