September 16, 2021

Covered Call ETF Explained

Covered Call ETF Explained

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What is a covered call ETF?

A covered call ETF is actively-managed to buy a stock index or individual stocks to use to write out-of-the-money call options on. They systematically use the covered call-option writing process to create returns through both capital gains on the held assets along with option premium from short call options. 

The covered call ETF gives its investor the benefit from profiting from a covered call system without having to manage the options and stock positions their self. The ETF does all the work of managing the strategy. 

Most of these types of ETFs write out-of-the-money (OTM) short-term call options of a month or less at prices that are unlikely to lead to the underlying equity position being called by expiration. The focus is to profit from time decay on the short call options and also profit from the underlying equity going up but not enough to be in-the-money on the call.

Covered call ETFs can be profitable in both uptrends benefiting from some capital appreciation or sideways markets where the fund collects the option premium. This type of ETF can lose money in downtrends when the underlying equity position loses more money than the covered call write makes in volatile markets where the stock position loses money and then the covered call caps the profits in a big rebound in price later. Brief volatility can give the ETF an opportunity to benefit from writing more expensive call options due to higher Vega value. 

Two popular covered call ETFS are XYLD and QYLD.

The Global X S&P 500 Covered Call ETF (Ticker XYLD) buys the stocks in the S&P 500 Index and sells call options on the index holdings. Its goal is to create performance results that correlate closely in price and yield returns (before fees and expenses) to the Cboe S&P 500 BuyWrite Index. It’s goal is to payout monthly distributions as an income fund. 

Is XYLD a good investment? It can give an investor exposure to covered call writing without the work of execution and also exposure to the reliable capital gain performance of the S&P 500. Its current dividend yield is +9.64% and its expense ratio is 0.60%.

The Global X Nasdaq 100 Covered Call ETF (Ticker QYLD) buys the stocks in the Nasdaq 100 index and sells call options on the index holdings. Its goal is to create the performance results that correlate closely in price and yield returns (before fees and expenses) to the Cboe Nasdaq-100 BuyWrite V2 Index.

Is QYLD a good investment? It can give an investor exposure to covered call writing without the work of execution and also exposure to the aggressive capital gain performance of the NASDAQ 100. Its current dividend yield is +11.42% and its expense ratio is 0.60%.

Since the majority of the returns on these ETFs come from monthly yield distribution they are best used as income producing investments not for long term capital gains or compounding returns for growth. The income returns are taxed like dividend income so that is important to consider for the tax implications. The best use of these ETFs for long term returns and growth could be inside an IRA where the yield is tax deferred and can be reinvested back into the ETF by buying more shares. 

These were created to be high income producing yield investments.