If you have been spending time in investing circles on social media, you have surely heard of covered call ETFs. These are especially popular amongst dividend and income investors. So, what is a covered call ETF? As the name suggests, these ETFs hold a portfolio of stocks around which covered call options are written.
Almost every major ETF provider has a covered call ETF these days. As with any investment asset, these funds have their pros and cons. More than any other type of ETF, covered call ETFs have a specific purpose.
Their role in your portfolio is to generate as much income as possible through quarterly or monthly distributions. This article will discuss the benefits of covered call ETFs and why they have become popular among income investors.
Table of Contents
What Is a Covered Call?
Before we get into the details of a covered call ETF, it is best to review what a covered call is. If you already know, then go ahead and skip past this section. But if you want a refresher, let’s dive into the options strategy many people adopt.
A covered call is an options strategy that provides additional income on shares you already own. Despite owning the stock, selling a call option is typically seen as a bearish trade. Why? Because you are betting on the stock price staying below the option’s strike price. With the call option, you get two possibilities:
- The stock price stays below the strike price, and you collect the premium and keep your shares.
- The stock price rises above the strike price, and you collect the premium, but your shares are assigned away.
Why is it called a covered call? Because you are selling a call option on shares you already own. You already have the shares to give away if the second outcome occurs. But if you don’t own the shares, you will have to cover the cost for 100 shares of that stock. As a result, this is a naked call option because you don’t own those shares. Assigning shares away when you do not own them can be an expensive lesson!
When you sell the call option, you collect the premium the buyer pays for the contract. No matter what happens with the trade, you keep that premium. Therefore, this can be a great source of income for options traders with a relatively low level of risk.
Covered Call Example
To illustrate this process, let’s take a look at an example of a covered call:
Let’s say you own 100 shares of Apple (AAPL) stock and want to sell covered calls on it.
For simplicity’s sake, let’s say AAPL shares sell at $100 per share.
If you sell the $102.00 covered call on a weekly expiration, you earn $100 in premium.
Now, in the first outcome, AAPL stock stays at $100. You keep the $100 premium and your 100 shares of AAPL.
However, in the second outcome, AAPL stock rises to $103.00 by expiration. You keep the $100 premium, but you sell your 100 shares of AAPL at $102.00.
So let’s break this down:
Again, for simplicity’s sake, let’s say you also bought those shares for $100.00.
So you sold them for $102, which means you made $200.00 in profit. You also earned the $100 in premium. In this case, you are up by $300.
But on the flip side, if you had kept your AAPL shares, you would have had the same gain but unrealized. Would you have sold your AAPL shares at $103?
When you sell covered calls, you have the cash in hand rather than holding the shares for the long term. You can always wait to re-buy those AAPL shares at a lower price and sell more covered calls against them!
What Is a Covered Call ETF?
A covered call ETF holds a basket of stocks against which the fund manager writes covered calls. It seems pretty simple. Not only do you get capital appreciation from the stock prices, but you also get an income bonus from premiums. As a result, this is one of the main reasons covered call ETFs pay such a high distribution yield.
It is common to see covered call ETFs paying a double-digit yield. On top of that, most of them will pay dividends monthly rather than quarterly. Therefore, this concerns how options contracts expire, and most funds are likely writing monthly calls.
The premium dividend payments are one of the primary reasons people invest in these ETFs. For those who want more stability against market volatility and a high monthly distribution, covered call ETFs have a place in your portfolio!
What Are the Best Covered Call ETFs?
If you’re new, practice trading before trading an advanced options strategy. We’ve got you covered with an options trading course. There, you can learn the basics of options. Once you’ve mastered the basics, you can move on to the more advanced strategies.
If you’re looking for ideas of covered call ETFs, you should trade them. Let’s look at several options you have for trading this style.
1. Global X Nasdaq 100 (QYLD)
QYLD is one of the more popular covered call ETFs on the market. It sells covered calls against NASDAQ 100 stocks like Microsoft, Apple, Alphabet, Amazon, and Tesla. QYLD has seen some of the best capital appreciation among covered call ETFs.
Since its inception, it has returned an impressive 97.5% since 2013. It does not even include re-invested dividends. As of April 2023, QYLD is sporting an 11.95% monthly yield with an expense ratio of 0.60%. Global X also provides an S&P 500 version of this ETF, which trades under the XYLD ticker.
2. JPMorgan Equity Premium Income (JEPI)
Another popular covered call ETF on social media, JEPI, was established in 2020. This fund sells options on S&P 500 stocks, focusing on financials and high-dividend paying stocks. Its largest allocations are to the Progressive Corp, Abbvie, Hershey Co, UnitedHealth Group, and the Coca-Cola Company.
JEPI currently pays a monthly yield of 8.88% with a much more reasonable expense ratio of 0.35%. JPMorgan also has a NASDAQ 100 version of this ETF, which trades under the ticker JEPQ.
3. YieldMax TSLA (TSLY)
Here is an even newer ETF than JEPI, established in November 2022. TSLY sells options solely against Tesla stock. It is an interesting strategy that has thus far paid some incredible dividends. Tesla stock typically has some of the higher options premiums because of its volatility.
It makes the returns on this ETF pretty generous. For example, while the 30-day SEC yield is a modest 2.66%, the actual yield is currently 68.43%! With monthly distributions of close to $1.00 per share, TSLY is a dividend-paying monster. It does have a higher expense ratio of 0.99%, so use your discretion when investing in TSLY.
Pros and Cons of Covered Call ETFs
Pros
- Incredible income stream through high-yield monthly dividends
- Acts as a hedge against market volatility
- You don’t have to worry about trading options yourself
- Available to be traded in any investment account
Cons
Final Thoughts: Covered Call ETF
A covered call ETF plays a specific role in investment portfolios. In retirement accounts, they can provide a great cash flow to grow your investments. At this point, you do not necessarily need to see capital appreciation. Retired investors would rather have steady dividends and more stable price action.
For younger investors, covered call ETFs probably won’t be a big part of your strategy. You can focus on growth for the long term and allow time and compounding to grow your portfolio organically.
Two things to be aware of: covered call ETFs can be difficult for taxes. ETFs like QYLD consider dividends to be short-term capital gains through options trading. JEPI utilizes equity-linked notes to earn interest. Therefore, this allows the dividends to be taxed as normal income. Be aware of the tax implications of the covered call ETF before holding it.
The other thing to be aware of is the higher MER or expense ratios. These can eat into your gains over the long run. The expense ratio is a percentage of your total holdings you must pay as fees. As a result, this is the primary method by which ETF providers earn income. If you oppose paying higher fees, covered call ETFs might not be for you.
In the end, this is a personal choice. During market volatility, covered call ETFs can provide excellent income while protecting your capital. Research and determine if covered call ETFs belong in your investment strategy!
Frequently Asked Questions
It does well in a sideways to bullish market. Learning this strategy can make you money in an otherwise boring market.
A covered call ETF cost is typically 0.78% of the expense accrued.
Like with any trading strategy, it can lose money if the trade goes against you. If you have proper risk management, you protect yourself from loss.
You'll pay higher taxes if you profit significantly on a covered call ETF.
