Benefits of a Covered Call ETF

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.

Analyzing the Strategy

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 and generates a profit in the process, it is considered a covered call.

A key to the covered call approach is that the call option buyer must pay a premium to buy it. That means smaller losses if the asset declines in value. The seller can also benefit if it goes up in price, provided the calls were out of the money.

Studies have analyzed the strategy of selling covered calls. Whether the strategy results in higher profits is decided by broader economic factors. For instance:

• One study commissioned by the CBOE Options Exchange showed an 830% return to the at-the-money covered calls strategy between June 30, 1986, and December 31, 2011. During that same period, the S&P 500 went up 807%.
• Another study by FTPortfolios found the covered call strategy outperformed the S&P only in four years between 2003 and 2021.
• A 2023 analysis by Morningstar compares a covered-call fund, the J.P. Morgan Equity Premium Income fund, which seeks to generate income using stock dividends and options premiums, to the SPDR S&P 500 fund. The J.P. fund had a 12-month yield of 10.01% as of October 31, 2023, compared to a 1.56% return of the SPDR S&P 500 fund. The two were compared between 2019 and 2023 and throughout that time, the J.P. fund had higher returns.

Potential for Higher Returns

The key to this strategy's success is that the value of covered calls on the S&P 500 goes up when volatility goes up as measured by the CBOE Volatility Index (VIX). 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 its 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 lower 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 (ATM) calls had between 30% to 40% less volatility than the S&P 500 itself. This figure is derived from a 2012 volatility study and a 2019 volatility study, both by CBOE.

According to Jonathan Molchan, former portfolio manager and head of product development for 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, ATM-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.

ETF Simplification of Covered Calls

Covered calls are relatively straightforward, but can be 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.

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.