Covered Call ETFs: What They Are and How They Work

There are garden variety exchange-traded funds (ETFs), and then there are the more exotic breeds that capture the imagination of savvy investors. Among these, covered call ETFs stand out as a sophisticated choice. They passively track an index and actively engage in selling call options on the stocks they hold, weaving a strategy for income generation and risk moderation. 

In this guide, we’ll explore the ins and outs of covered call ETFs, including how they add a unique flavor to your investment portfolio, the nuances of their operation, and their potential benefits and limitations.

What is a covered call ETF?

To understand covered call ETFs, let’s first review covered calls and covered call options strategy.

A classic covered call is a stock’s simultaneous ownership alongside a call option’s sale on that same stock. This strategy is referred to as writing covered calls. A call option gives the option holder the right, but not the obligation, to purchase a particular stock at a specified price within a predetermined time frame, while the person selling the option earns a premium profit. 

By extension, covered call ETFs provide the premium income derived from selling call options while benefiting from the potential price appreciation of their underlying stock holdings. 

Several well-established and popular covered call ETFs make for good examples, including the Global X S&P 500 Covered Call ETF (XYLD), the Global X Nasdaq 100 Covered Call ETF (QYLD), and the Global X Dow 30 Covered Call ETF (DJIA). All these ETFs allow investors to generate income while reducing the volatility associated with direct stock ownership.

How do covered call ETFs work?

Covered call ETFs combine the benefits of holding a diversified portfolio of assets with the income-generating potential of selling call options on those assets. Here's how they work in even greater detail:

1. Diversified asset basket

A covered call ETF begins with a basket of underlying assets, typically stocks. Fund managers attempt to buy the best stocks for covered calls, carefully selecting them to match the ETF’s overarching investment objectives and strategy.

2. Call options selling

The ETF manager or fund sponsor, acting on behalf of investors, sells call options on the underlying assets held by the fund. A call option gives the buyer (usually a trader or investor) the right (again, no obligation) to purchase the underlying security at a specified price (aka strike price) within a predetermined time frame (or the option's expiration date).

3. Income generation through premiums

By selling these call options, the ETF collects premiums from buyers. The premiums are an upfront payment made by the call option buyers to the ETF. This process generates income for the ETF, which is then distributed to the fund's investors in the form of dividends or distributions.

4. Risk management

A covered call ETF primarily aims to generate income for its investors while reducing the potential downside risk. Meanwhile, the ownership of the underlying assets provides stability and potential for capital appreciation.

5. Limited upside potential

It's important to note that the strategy of covered call writing comes with a trade-off. By selling call options, the ETF caps its potential upside gains. If the underlying assets rise significantly in price and are called away (i.e., if the buyer exercises the options), the ETF may miss out on those gains beyond the strike price. 

This strategy’s efficacy can vary with market conditions. For example, in a flat or moderately rising market, covered call ETFs can outperform as they generate income from option premiums. Conversely, in a rapidly rising market, they might underperform due to the capped upside.

6. Investor considerations

Investors in covered call ETFs typically prioritize income over capital appreciation. This makes these ETFs appealing to those seeking regular income, such as retirees. 

While the income component is attractive, investors also need to understand the risk-return trade-off, especially the potential for limited capital growth.

Pros and cons of covered call ETFs

Investing in covered call ETFs can be a strategic move for certain investors, offering unique benefits while also presenting specific challenges. These ETFs combine the principles of traditional ETF investing with the options market to create a distinct financial product. Understanding their pros and cons is crucial for investors to determine if they align with their investment goals and risk tolerance.

Covered call ETF pros 

Income generation

The major allure of covered call ETFs is their ability to generate income. By selling call options on the underlying assets, these ETFs collect premiums, providing investors with a steady cash flow. This income can be particularly appealing for retirees seeking regular payouts.

Returns in stable markets

Covered call ETFs tend to thrive in stable or slightly bullish market conditions. They perform well when markets experience modest price gains, allowing investors to capture gains while collecting income in the form of options premiums. In a sense, these ETFs offer a way to capitalize on stability.

Professional management

Covered call ETFs are usually actively managed by experienced professionals. Fund managers select the underlying assets and execute the options strategies. In the best-case scenario, they optimize returns and limit risk effectively. 

Risk mitigation

Covered call ETFs aren’t immune to market downturns, but the strategy of covered call writing can help mitigate some of the downsides. The premiums received from selling call options provide a cushion against losses.

Covered call ETF cons 

Underperformance in bull markets

Covered call ETFs sometimes underperform during strong bull markets, as it involves selling the upside potential of the underlying assets through call options. When stocks experience substantial price increases, the ETF may miss out on those gains beyond the options’ strike prices.

Complexity

Covered call ETFs’ options strategies can be complicated, involving multiple contracts with varying strike prices and expiration dates. This complexity may make these ETFs less suitable for novice investors struggling to fully understand the intricacies and possible consequences of options trading.

Higher costs

Managed ETFs, including covered call ETFs, usually come with increased expense ratios, four or five times higher than passively managed ETFs. In a low-yield or low-returns environment, these fees may have a more pronounced impact on overall returns.

Risk of market declines

While a covered call strategy can help manage risk, they don’t eliminate it altogether. These ETFs are still subject to market declines, and during severe market downturns, they can experience significant losses. It's essential for investors to consider their risk tolerance and investment goals before adding these ETFs to their portfolios.

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