Many investors may be wary of derivative-based funds and strategies. Compared to regular index funds, they tend to be more complicated, pricier and difficult to understand. However, when employed properly or managed by a competent fund manager, derivative strategies can drastically transform the risk/return profiles of average investments.
A great example? Covered call exchange-traded funds, or ETFs, which take ordinary assets like stocks, bonds and even commodities and turn them into income-generating juggernauts by selling options.
“Covered call writing involves selling call options on stock positions you own,” says Robert Johnson, professor of finance at Creighton University’s Heider College of Business. “Essentially, a covered call writer is forgoing some upside potential in exchange for additional current income.”
By selling call options, the writer agrees to sell the underlying shares at a set price, called the “strike,” in return for a cash premium.
“Typically, the closer the strike price of the call sold is to the price level of the asset initially, the higher the potential is for a higher premium,” says Chandler Nichols, product specialist at Global X ETFs. Other factors like the option’s time until expiry and the implied volatility of the underlying asset also play a role in determining the size of options premiums.
As a strategy, covered calls are most suitable for moderately bullish investors seeking above-average current income. “Because writing call options on an existing long position in an underlying asset forfeits a level of upside potential, there are certain market environments where we’d expect covered call strategies to outperform and underperform,” Nichols says.
In general, covered call strategies underperform when the underlying asset experiences sustained uptrends. If the underlying asset falls, a covered call strategy can offset losses somewhat through the premium received. However, a covered call strategy can outperform during a flat or choppy sideways market as the options sold expire worthless and the writer continually pockets a premium.
“With a covered call ETF, the stock purchase, portfolio management and call writing decisions are left to a professional” – Robert Johnson, finance professor at Creighton University’s Heider College of Business.
In particular, high-volatility market conditions like those experienced in 2022 tend to be beneficial for covered call strategies. “A covered call strategy’s income is derived from options premiums, which are influenced by the implied volatility of the underlying asset,” Nichols says. “Therefore, the higher the implied volatility, the higher the anticipated option premium, all else being equal.”
Because writing options can be complicated and time-consuming for many investors, an alternative is to buy an ETF that incorporates a covered call strategy. “With a covered call ETF, the stock purchase, portfolio management and call writing decisions are left to a professional,” Johnson says. “By buying a covered call ETF, one doesn’t have to continuously monitor both the stock and options markets.”
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Here’s a look at seven of the most popular covered call ETFs trading on the market right now:
| Covered Call ETF | Trailing 12-Month Yield |
| Global X Nasdaq 100 Covered Call ETF (ticker: QYLD) | 12.8% |
| Global X S&P 500 Covered Call ETF (XYLD) | 13.2% |
| Global X Russell 2000 Covered Call ETF (RYLD) | 14.3% |
| Global X S&P 500 Covered Call & Growth ETF (XYLG) | 6.1% |
| Nationwide Nasdaq-100 Risk-Managed Income ETF (NUSI) | 8.1% |
| Amplify CWP Enhanced Dividend Income ETF (DIVO) | 4.8% |
| FirstTrust Cboe Vest S&P 500 Dividend Aristocrats Target Income ETF (KNG) | 4% |
Global X Nasdaq 100 Covered Call ETF (QYLD)
One of the largest providers of covered call ETFs is Global X ETFs. In addition to their thematic lineup, Global X offers a suite of covered call ETFs tracking various indexes and sectors, with varying levels of options coverage. One of their most popular ETFs is QYLD, which tracks the tech- and growth stock-heavy Nasdaq 100 index with a covered call overlay.
By selling at-the-money, or ATM, calls systematically, QYLD is able to produce a very high level of monthly income. Thanks to the high volatility of the underlying Nasdaq 100 index, QYLD’s premiums are sizable. Right now, the ETF’s 12-month trailing yield clocks in at 12.8%. QYLD has managed to make monthly distributions for nine years running. The ETF charges a 0.6% expense ratio, or $60 annually per $10,000 invested.
Global X S&P 500 Covered Call ETF (XYLD)
Not all investors like the Nasdaq 100. Some investors may dislike it due to its exclusion of non-Nasdaq-listed stocks and financial sector stocks. Others may dislike it for a high concentration of tech sector and growth stocks. For a more balanced approach to covered call strategies, investors can opt for XYLD, which is basically QYLD but with the S&P 500 as the underlying index.
Like QYLD, XYLD’s strategy is simple. The ETF sells ATM covered calls against 100% of its overall holdings periodically to generate high, sustained monthly income. Like QYLD, XYLD has also made monthly distributions for nine years running. Its 12-month trailing yield currently sits at 13.2%, but keep in mind that this can fluctuate. It also charges a 0.6% expense ratio.
Global X Russell 2000 Covered Call ETF (RYLD)
Both QYLD and XYLD focus on large-cap stocks due to the nature of their underlying indexes. For an income-focused approach to small-cap investing, investors can pick RYLD, which uses the Russell 2000 index as its underlying asset. Thanks to the higher volatility of small-cap stocks, RYLD currently sports a 12-month trailing yield of 14.3% against the usual 0.6% expense ratio. That being said, RYLD may not be for everyone.
“Writing call options on high-volatility indexes may cap your upside potential if the index runs up but still expose you to significant downside volatility if the index turns south,” says Mark Andraos, associate portfolio manager at Regency Wealth Management.
By selling covered calls, investors also run the risk of capping the higher upside potential that small-cap stocks can potentially deliver.
[See: 7 Best ETFs to Buy Now.]
Global X S&P 500 Covered Call & Growth ETF (XYLG)
A common criticism of ETFs like QYLD and XYLD is that they cap upside returns completely by selling ATM calls on 100% of their portfolio. While this can maximize current income, it tends to severely limit future growth. For a more moderate approach, investors can consider ETFs like XYLG, which limits the covered call overlay to just 50% of the ETF’s underlying holdings.
By doing so, XYLG can capture half the upside potential of the S&P 500 index, while still delivering above-average income. Case in point, XYLG currently pays a 12-month trailing distribution of 6.1%, which is still much higher than the vanilla index on its own. For investors that don’t require very high monthly distributions, ETFs like XYLG can be a good compromise.
Nationwide Nasdaq-100 Risk-Managed Income ETF (NUSI)
“There is a common misconception that covered call ETFs are hedged strategies,” Andraos says. “They are not ‘hedged’ in the traditional sense, as you are still subject to the same downside market risk as the underlying equities or index the ETF owns, with your losses cushioned slightly by the income generated by the options premium.” For a hedged alternative, investors can consider NUSI.
This ETF starts by selling Nasdaq 100 index call options, much like QYLD does. However, NUSI also uses a portion of the premium received to purchase out-of-the-money, or OTM, put options on the Nasdaq 100 index. This results in a “collar” strategy, where both upside potential and downside risk are limited. The remainder of the premium is paid to investors in the form of an 8.1% trailing 12-month yield.
Amplify CWP Enhanced Dividend Income ETF (DIVO)
A five star-rated covered call ETF in the derivative income category from Morningstar is DIVO, which combines active stock selection with a tactically managed covered call writing strategy. Unlike the previous ETFs, DIVO does not track an index. Rather, its managers select and manage a portfolio of 20 to 25 large-cap U.S. dividend stocks and use covered calls to produce a 4.8% trailing 12-month yield.
Stocks in DIVO are selected for quality characteristics like strong historical earnings and dividend growth, good management track record, free cash flow growth and high return on equity. The managers are also free to adjust sector weightings as they deem fit. Finally, the ETF can write covered calls in a non-systematic way based on the manager’s assessment of different market factors.
FirstTrust Cboe Vest S&P 500 Dividend Aristocrats Target Income ETF (KNG)
Another way to combine dividend stocks with covered calls is via KNG. This ETF tracks an equally weighted portfolio of stocks represented by the S&P 500 Dividend Aristocrats Index, which screens all holdings for a minimum of 25 consecutive years of dividend increases. Then, the ETF continually writes short-term covered calls on no more than 20% of the value of each underlying dividend aristocrat.
The strategy is twofold. First, KNG combines the regular dividend yield from its dividend aristocrats along with the covered call income to target a yield 3% higher than that of the regular S&P 500 index. Second, by leaving the majority of its portfolio uncovered, KNG can still participate in upside share appreciation. The ETF currently pays a 12-month trailing yield of 4% and charges a 0.75% expense ratio.
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7 High-Yield Covered Call ETFs Income Investors Will Love originally appeared on usnews.com
Update 04/11/23: This story was previously published at an earlier date and has been updated with new information.
