INVESTING
Covered Call ETFs: How Do They Work & Which Can You Buy?
…and one great big catch.
Covered calls are a simple way to coax more yield out of shares you own (or plan to buy).
If you don’t know what they are, then here is a detailed guide that starts from scratch. I’ll also give a quick-and-dirty summary in just a second.
While covered calls always involve some judgment, they can be a pretty mechanical strategy. So mechanical, in fact, that you might trade a few and then start to wonder…
Why isn’t there a fund that just does this?
It turns out there is. And not just one, but a handful. In this article, I’ll share several worth knowing about, plus some important caveats.
I’m not a financial professional. This is purely opinion and entertainment, not advice. Do what’s right for you, and if in doubt about what that is, then it’s important to find someone who’s legally able to tell you.
Background: how covered calls work
A covered call involves selling (“writing”) a call option on a block of 100 shares you already own.
Without getting into the details—again, I’ve done that here—you’re effectively increasing cash flow by selling off your upside past a certain point.
The closer that point is to the current share price, the more money (“premium”) you’ll collect, but the more likely your shares will be called away. It’s a balancing act between those two factors.
The point is that you can turn slow-growing or stagnant shares into regular cash flow…to the tune of 0.5%-2% of equity value each month.
Of course, returns vary like crazy. You can chase far higher yields from more volatile assets (here’s why I wouldn’t), or you can accept less in return for a minimal chance of assignment. Either way, they’re a great cash flow tool in the right hands.
The goal of covered call ETFs
What if you don’t have the time or desire to be hands-on with your portfolio?
There’s nothing wrong with that. In fact, there’s strong evidence that inactive investors tend to get better returns than those who tweak and tinker.
For a long time, that meant covered calls (and the easy cash flow they bring) were basically DIY, except through relatively complex or illiquid instruments, like certain mutual funds or fixed-income products.
But more recently, a few ETFs have provided a way to “outsource” this strategy in a package that’s as accessible as any other shares.
The idea is simple:
- The fund owns a large basket of stocks, enough to track the base index if applicable.
- Fund managers sell calls against the index itself and/or the basket of stocks. Some use only a portion of the holdings; some also use other long or short options at the same time.
- Management may reinvest some capital gains and premium, but distributes a lot in order to maximize cash flow (since that’s exactly what attracted most shareholders).
Of course, different funds have different approaches to strikes, expirations rolling/closing criteria, etc. Nobody enjoys reading a prospectus, but this is one case where it’s worth slogging through.
Pardon the interruption, but if you're with me this far, then consider joining through this referral link to see *everything* Medium has to offer!What covered call ETFs are available now?
According to ETF.com, nearly 30 covered call ETFs are available now. All involve covered calls, and some use additional strategies as well. I’ve excluded many other income ETFs that don’t revolve around covered calls
Below are the listings I consider noteworthy, in no particular order. (I don’t necessarily endorse or recommend any of them, and I can’t guarantee that the info is up to date.)
Most attributes are self-explanatory, but overwrite might be a new concept. That’s the percentage of holdings that the fund sell calls against. For instance:
- If you had 200 shares of Apple and sold two covered calls, your overwrite percentage would be 100%.
- If you had 200 shares and sold one call, your overwrite percentage would be 50%.
A higher percentage means more premium (since more contracts are sold) but less equity upside (since more contracts may also be assigned).
Anyway, on to the funds.
QYLD
- Index: Nasdaq 100
- Strategy: covered calls (buy-write)
- Overwrite: 100%
- Moneyness: at the money
- Manager: Global X
- Expense ratio: 0.60%
XYLD
- Index: S&P 500
- Strategy: covered calls (buy-write)
- Overwrite: 100%
- Moneyness: at the money
- Manager: Global X
- Expense ratio: 0.60%
RYLD
- Index: Russell 2000
- Strategy: covered calls (buy-write)
- Overwrite: 100%
- Moneyness: at the money
- Manager: Global X
- Expense ratio: 0.60%
DJIA
- Index: Dow Jones 30
- Strategy: covered calls (buy-write)
- Overwrite: 100%
- Moneyness: at the money
- Manager: Global X
- Expense ratio: 0.60%
QYLG
- Index: Nasdaq 100
- Strategy: covered calls (buy-write)
- Overwrite: 50%
- Moneyness: at the money
- Manager: Global X
- Expense ratio: 0.60%
XYLG
- Index: S&P 500
- Strategy: covered calls (buy-write)
- Overwrite: 50%
- Moneyness: at the money
- Manager: Global X
- Expense ratio: 0.60%
PBP
- Index: S&P 500
- Strategy: covered calls (buy-write)
- Overwrite: 50%
- Moneyness: “at or above” the index price
- Manager: Invesco
- Expense ratio: 0.49%
KNG
- Index: S&P 500 Dividend Aristocrats
- Strategy: covered calls (buy-write)
- Overwrite: up to 20%
- Moneyness: at the money
- Manager: First Trust
- Expense ratio: 0.75%
QRMI
- Index: Nasdaq 100
- Strategy: collar (covered calls + protective puts)
- Overwrite: 100%
- Moneyness: short calls at the money; long puts 5% out of the money
- Manager: Global X
- Expense ratio: 0.60%
XRMI
- Index: S&P 500
- Strategy: collar (covered calls + protective puts)
- Overwrite: 100%
- Moneyness: short calls at the money; long puts 5% out of the money
- Manager: Global X
- Expense ratio: 0.60%
QCLR
- Index: Nasdaq 100
- Strategy: collar (covered calls + protective puts)
- Overwrite: 100%
- Moneyness: short calls 10% out of the money; long puts 5% out of the money
- Manager: Global X
- Expense ratio: 0.60%
XCLR
- Index: S&P 500
- Strategy: collar (covered calls + protective puts)
- Overwrite: 100%
- Moneyness: short calls 10% out of the money; long puts 5% out of the money
- Manager: Global X
- Expense ratio: 0.60%
JEPI
- Index: S&P 500
- Strategy: short options + ELNs
- Overwrite: discretionary
- Moneyness: discretionary
- Manager: JPMorgan
- Expense ratio: 0.35%
JEPQ
- Index: Nasdaq 100
- Strategy: short options + ELNs
- Overwrite: discretionary
- Moneyness: discretionary
- Manager: JPMorgan
- Expense ratio: 0.35%
NUSI
- Index: Nasdaq 100
- Strategy: covered calls + protective puts (collar)
- Overwrite: discretionary
- Moneyness: discretionary
- Manager: Nationwide
- Expense ratio: 0.68%
NSPI
- Index: S&P 500
- Strategy: covered calls + protective puts (collar)
- Overwrite: discretionary
- Moneyness: discretionary
- Manager: Nationwide
- Expense ratio: 0.68%
NDJI
- Index: Dow Jones 30
- Strategy: covered calls + protective puts (collar)
- Overwrite: discretionary
- Moneyness: discretionary
- Manager: Nationwide
- Expense ratio: 0.68%
NTKI
- Index: Russell 2000
- Strategy: covered calls + protective puts (collar)
- Overwrite: discretionary
- Moneyness: discretionary
- Manager: Nationwide
- Expense ratio: 0.68%
IGLD
- Index: SPDR Gold Shares
- Strategy: covered calls (buy-write)
- Overwrite: variable (lately 20%-30%)
- Moneyness: short calls at the money; long calls and puts out of the money
- Manager: First Trust
- Expense ratio: 0.85%
Other covered call funds
Several smaller ETFs operate similarly. Innovator manages complex funds with target equity returns over certain time frames; Credit Suisse manages ETNs linked to gold, silver, and oil.
these are tiny and obscure, with around $2M to $20M AUM as of writing, and no clear utility for individual investors. Interesting in principle, but not worth detailing here.
Are these a good idea?
The advantages of covered call ETFs
I see the case for this category of fund, since they do a few things that are out of reach for most of us individually.
Significant, passive cash flow
Their cash flow is effortless and almost guaranteed, although yield may vary tremendously.
Annualized yield of 7%-12% (or more!) is common these days, which puts them on par with all sorts of REITs, MLPs, and more arcane products.
They make index covered calls accessible
This is the easiest way to trade index covered calls, assuming you’re content with a very limited range of overwrite and moneyness.
That accessibility is important because you can’t directly “own” an index. It’s just a number, not an asset.
Instead, you’d either a) write index calls against a basket of its components or b) own and write calls against an index ETF (like QQQ or SPY). The former would require at least several hundred thousand dollars to buy the underlying basket, and some work to manage it. The latter is less expensive, but you’re still looking at five figures for 100 shares of a “cheap” index fund like QQQM.
Either way, you might not be willing or able to earmark that much capital for covered calls. And dollar-cost averaging in such increments is basically out of the question.
But covered-call funds hold all those 100-share blocks themselves. You can buy one share, or even fractional shares, of their combined value and premium.
Funds that use index options (not index ETF options) may also capture tax benefits that help offset their fees. I’m not too concerned either way, but I’d talk to an account before building a portfolio around these funds.
Problems with covered call ETFs
As always, there’s no free lunch. Here are four limitations—among others—that limit their place in my own portfolio.
Limited upside
You should be familiar with the drawbacks of covered calls before exploring funds that revolve around them.
Chiefly, they should outperform their benchmark in neutral and perhaps slightly upward or downward markets…but underperform badly in strong bull markets.
Remember, the whole premise of covered calls is to sell the rights to the upside. The more upside happens, the greater the opportunity cost.
For instance, QQQ appreciated nearly 23% in the past year, whereas QYLD grew just under 15% with distributions reinvested (about 2% on price alone).
Be wary of 100% overwrite
Related to the previous point, I’m especially wary of the popular *YLD family. Their 100% overwrite cuts off upside without significantly reducing downside, so risk-adjusted returns are poor.
Personally, the *CLR family make more sense, along with JEPI, NUSI, and their ilk. True, yields are lower due to OTM calls and long puts. But by the same token, they participate in upside and protect against downside. I’d start here if I needed to count on the income!
Costly management
Another other concern is the management fees. QQQ carries a 0.2% expense ratio versus 0.6% on QYLD. That widens the performance gap during good times and chips away at badly needed distributions during bad times.
Some, like IGLD, charge a rather painful 0.85%. I won’t say whether that’s worth it, but it should give you pause for thought.
Opaque, active strategies
Even if you don’t like managing your portfolio, you may still want to understand exactly how it works. Otherwise, it’s tough to understand what will happen in different conditions, or what trade-offs you’re really making.
For instance, writing .45-delta monthly calls versus .05-delta weekly calls will give very different results!
Unfortunately, not all funds are that clear. For instance, XYLG “sells one-month, at-the-money call options on up to 50% of each stock” in a basket that tracks SPX. But how much is “up to,” and who decides?
Many others are even less transparent, often involving elaborate ETNs and FLEX options that I’m not sure I even want to understand. They might just be protecting proprietary strategies, but it’s perfectly reasonable if the opacity gives you cold feet.
More fundamentally, some of us use ETFs specifically to avoid market timing and stock picking. Some of these funds, like the *YLD family, are totally accomplish that goal. Others use discretionary options strategies on discretionary underlyings.
Limited real-world results
Most (all?) of these ETFs were launched within the last decade. A basic knowledge of options is enough to make educated guesses about how they’ll perform in different conditions, but there isn’t much of a real-life track record.
That’s not a criticism, just a general caveat. Besides, my own covered calls are probably less systematic…and definitively have less of a track record.
Covered call ETFs are an interesting and oft-overlooked class of funds.
They seem like a compelling alternative to fixed-income products for older investors, and a nice way for younger investors to hedge against volatility (to a degree) while holding on to some upside.
If index or large-cap covered calls are a good fit for your portfolio, then several of these funds can provide that monthly cash flow without that monthly management.
Make sure you understand the intricacies of the management strategy before diving in, since these don’t behave quite like index ETFs — for better or for worse.
Disclosure: long positions in some of the above as of publishing.
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