Covered Call ETFs: A Smart Income Play In Volatile Markets

During unpredictable times, investors tend to look for ways not only to hedge their investments but also to earn higher income.

Covered call ETFs are gaining popularity as a means of earning income, particularly during turbulent market periods. These specialized ETFs boast a strategy that can generate a consistent stream of income for the investor.

The market provides different covered call ETFs with differing investment preferences. Some follow broad market indexes such as the S&P 500 and the Nasdaq 100, writing call options against these indexes. Others target particular sectors such as small-cap stocks in the Russell 2000 index. There are sector-specific ETFs as well, with focus on technology, financials, or energy.

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These ETFs may be rules-based, adhering to a predetermined strategy, or actively managed, where fund managers modify the strategy according to market conditions. Below are a few examples:

• Global X Funds Global X S&P 500 Covered Call ETF XYLD: Follows S&P 500. The fund has a 12-month yield (the yield an investor would have received had they held the fund over the last twelve months) of 12.58% and an expense ratio of 0.60%

• Global X NASDAQ 100 Covered Call ETF QYLD: As the name suggests, the ETF tracks the Nasdaq 100. It has a 12-month yield of 13.96% and an expense ratio of 0.60%.

• Global X Russell 2000 Covered Call ETF RYLD follows the Russell 2000, has a 12-month yield of 11.9% and carries an expense ratio of 0.60%.

Why Covered Call ETFs Will Shine Through Volatility

Covered call ETFs are appealing in volatile markets. Increased volatility usually results in higher call option premiums. This increases the chances of these ETFs to earn more income. In addition, the received premium provides partial downside protection in turbulent market conditions, which acts as a cushion against market declines. Such ETFs do best in sideways or moderately bullish markets.

A covered call strategy basically means owning stock shares and writing call options on them. The option buyer pays a premium for the privilege of being able to buy the shares at a predetermined price (strike price) by an expiration date. A covered call ETF applies this strategy to a diversified portfolio of stocks, leaving the intricacies of options trading to investors.

These ETFs make money by owning a portfolio of shares, typically an index-tracking fund. They then sell call options on some or all of the shares. The key source of cash is the premium from selling them.

If the price remains below the strike price when it expires, the option lapses worthless, and the ETF retains the premium. If the price goes higher than the strike price, the option can be exercised. The ETF will sell the stock at that level, potentially capping further profit. The earned revenue is shared with the investors.

The Other Side Of The Coin

Drawbacks of these ETFs are capped upside potential, where gains will be limited if shares increase in price. They provide no downside protection. Income may vary inversely with market fluctuations. Expense ratios tend to be higher than for standard index funds.

Dividends from these ETFs are taxed at the lower qualified dividend rate (0%, 15%, or 20%) if IRS conditions are met. Premiums from selling call options in an ETF portfolio are taxed as short-term capital gains at the investor’s ordinary income tax rate, which is typically higher.

Covered call ETFs may be an excellent source of generating income, particularly during uncertain times. That being said, investors should recognize the compromises and think carefully about their investment goals and risk tolerance prior to making a commitment.

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