Everything You Need to Know About Covered-Call ETFs

Everything you need to know about covered call ETFs is provided in this article.

This article providing everything you need to know about covered call ETFs, also known as exchange-traded funds, will explain:

• What a covered call ETF is and how it works
• The types and examples of covered call ETFs
• Benefits & risks of covered call ETFs
• Bottom Line: Should you invest in covered call ETFs?

This article provides important details regarding covered call ETFs that investors can use to optimize their decision making and ideally their results.

What is a Covered Call ETF and How Does It Work?

To understand what a covered call ETF is, we must first define a covered call.

A covered call is an options strategy where an investor writes a call option for a stock that he already owns. The covered call is used when an investor expects the underlying stock to have a slight increase or decrease in price. This is not a strategy to use when an investor is heavily bullish, or bearish.

By using this strategy, an investor earns a premium regardless of what happens to the underlying stock’s price. However, this strategy puts a limit or cap on the stock’s upside profit potential.

Let’s look at an example: Assume an investor owns stock XYZ. XYZ is trading at $20. The investor sells a call option for XYZ that expires in a month with a strike price of $23. The investor receives a premium of $2 per share for selling the option. However, he limits the potential gain on the stock to $23.

This example will play out in three possible outcomes:

–    If ABC rises to $23 at expiration, then the call option will be exercised and the investor, who sold the call option, will be obligated to sell his shares of the stock. The investor will make $3 per share (23 – 20 = 3) plus the premium of $2 per share. If the investor was planning to sell the stock at $23, then this would be a good scenario as he profits by an extra $2 per share as a result of the premium.

–    If ABC rises to $30 at expiration, then the call option will be exercised and the investor, who sold the call option, will be obligated to sell his shares of the stock. He would be required by the option contract to sell the shares at $23, thus giving him a profit of $3 per share plus the premium of $2 per share. However, if he did not sell a call option for this stock, then he would still be the owner of the stock when its price was $30. That is a profit of $10 per share. By selling the call option, the investor puts a limit on his potential profit.

–    If ABC falls to $19, then the option would expire worthlessly. The investor, who sold the call option, still gets $2 per share for the premium. However, he loses $1 per share because of the stock’s price fall. The premium helps offset the decline in stock price.

These three scenarios show the possible results of executing the covered call strategy. An investor will get his best result from the strategy if the stock price remains relatively neutral. If this happens, the investor walks away with the premium while still owning shares of the stock.

A covered call ETF is similar to an ordinary ETF in the sense that it holds a basket of stocks. However, covered call  ETFs engage in the process of placing call options on all of the stocks within the ETF and selling them to option investors for premiums to generate premium income from the ETF. Covered call ETFs also traded like stocks during market hours, and a defining aspect of these ETFs is that they’re actively managed. It gives investors exposure to the options market without them having to directly participate because by owning these ETFs, call options are already written on the stocks within the ETF.

For example, PBP is a covered call ETF that tracks the S&P 500. On top of mimicking the returns of the stocks held in the ETF, the fund managers also would sell call options and collect premiums on them, then distribute those premiums to the holders of the ETF. Thus, these covered calls can be treated as dividends to the shareholders of PBP.

The Types of Covered Call ETFs

There are over 20 covered call ETFs traded domestically in the United States, and most of them are equity or commodity funds.

Below is a short list of covered call ETFs that you can explore:

• QYLD – Global X NASDAQ 100 Covered Call ETF
• XYLD – Global X S&P 500 Covered Call ETF
• RYLD – Global X Russell 2000 Covered Call ETF
• KNG –  FT Cboe Vest S&P 500 Dividend Aristocrats Target Income ETF
• SLVO – Credit Suisse X-Links Silver Shares Covered Call ETN
• PBP – Invesco S&P 500 BuyWrite ETF
• USOI – Credit Suisse X-Links Crude Oil Shares Covered Call ETN
• GLDI – Credit Suisse X-Links Gold Shares Covered Call ETN

Benefits and Risks of Covered Call ETFs

The major benefit of Covered Call ETFs is that they allow investors to make money when the stock market is neither going up or down but is moving sideways. This is because of the premium income generated by selling the call options.

In addition, Covered Call ETFs offer some level of downside protection if the stock market declines. The premium income could partially or fully offset the decline in the stock market.

Like traditional ETFs, covered call ETFs also offer the benefit of diversification to a portfolio rather than just making covered calls on individual stocks. Furthermore, investors in covered call ETFs don’t need to be active traders and place their own stock or options trades. Instead, the fund managers manage the investments for them, which helps them earn passive income from the options trades.

Aside from the benefits, there are also risks that need to be addressed regarding these ETFs. Given there are fund managers buying and selling these options, the expense ratios are higher because they’re actively traded. Furthermore, there is more growth potential than owning stocks because covered calls limit the upside if stock prices are going up.

Bottom Line: Should You Invest in Covered Call ETFs?

Covered call ETFs are actively managed funds in which call options are placed on the stocks within the funds. This is a sound investment strategy if the investor believes the stock market is going to stay relatively stable or even moderately decline.

They are a much less attractive investment strategy if the investor expects a significant increase or decline in stock prices.