Covered Call ETFs

Exchange-traded funds (ETFs) are highly versatile investment instruments thanks to their ability to track a wide variety of underlying assets. Today, the types of ETFs on the market include ones that hold stocks, bonds or commodities.

Some more exotic ETFs can employ derivatives, such as swaps, futures and options. These ETFs often use derivatives to change their risk/return profiles or target alternative investment objectives, such as lowering volatility or producing higher-than-average yields. 

A great example of ETFs that target the latter are covered call ETFs. These ETFs combine an underlying long equity position with a short call position, which caps their upside but has the potential to produce consistent, higher-than-average income. Here's all you need to know. 

What Are Covered Call ETFs?

Covered call ETFs are investments that combine equities and options to produce higher-than-average levels of income. A covered call ETF holds an underlying long equity position, while simultaneously selling call options against that position. By doing so, the ETF generates higher yields in exchange for reduced upside potential. 

Like all ETFs, covered call ETFs trade on exchanges throughout the day, with their own ticker symbol like a stock. Income investors who buy a covered call ETF do so with the expectation of receiving consistent monthly distributions, which can be a combination of dividends, short- or long-term capital gains or return of capital. 

How Do Covered Call ETFs Work?

Covered calls are considered a beginner options trading strategy because of their relative simplicity and predictable payoff profile. A covered call ETF is an even simpler way to implement this options strategy as the ETF manager handles the options writing and portfolio management. 

A covered call ETF starts by purchasing a portfolio of securities, which are usually equities but can be fixed-income assets or commodities. The selection process can be passively based on an index benchmark or actively managed based on the manager's own strategy and criteria. 

To generate income, the ETF manager will sell or “write" call options on a portion or the entire portfolio. To sell one call, the ETF manager must hold at least 100 shares of a security in the underlying portfolio. By doing so, the ETF manager commits to selling the 100 shares at the strike price if the buyer exercises the call.

By selling call options, the ETF receives a cash premium, the amount of which is based on several factors that all play a role: 

1. The strike price: This is the price at which the seller of the call agrees to deliver the underlying shares to the buyer if exercised. Call options can be sold with strike prices in-the-money (below the current market share price of the underlying), at-the-money (equal to the current market share price of the underlying) or out-of-the-money (above the current market price of the underlying). Generally, call options sold in-the-money or at-the-money will net a higher premium. 

1. The expiration date: This is the last day that the buyer of the call can exercise the option and buy 100 shares of the underlying at the strike price. Generally, call options sold with a later expiration date will net a higher premium.

1. Implied volatility (IV): This is the market's forecast of a security's likely movement in price. The higher IV is, the more uncertain the market is when it comes to pricing a security. Generally, call options sold when IV is higher will net a higher premium. 

The premium is combined with dividends from the underlying holdings and paid out to ETF investors as monthly income. As noted earlier, distributions from covered call ETFs can be taxed at different rates depending on the source (qualified dividends, short/long-term capital gains, return of capital), so it is important to consult the ETF's distribution documents. 

The best-case scenario for a covered call ETF is when the option expires just out of the money, allowing the ETF to keep the underlying shares and benefit from the premium. If the calls sold expire in the money, the buyer of the call may exercise. In this case, the ETF must sell its shares at the strike price and possibly miss out on a better market price. 

There's no universal rule for how covered call ETFs implement their strategy. Some ETF managers prefer to sell out-of-the-money calls expiring in one to two months on just half the portfolio to ensure some upside participation. Others prefer to sell at-the-money calls on all the underlying portfolios expiring in a month to maximize income. 

Therefore, it's important to conduct extensive research on any covered call ETF, especially on the underlying holdings and options writing strategy before you buy.

Benefits of Covered Call ETFs

Covered call ETFs tend to be popular investments with many income investors because of the following advantages:

High, consistent yields: Covered call ETFs tend to have much higher yields compared to other assets like real estate investment trusts (REITs), corporate bonds, preferred shares or dividend stocks. They also tend to pay out monthly, which is more frequent than the quarterly basis many other ETFs pay.

Hands-off nature: Covered call ETFs allow income investors to access an option selling strategy without needing to trade and manage an options position themselves. With a covered call ETF, investors can resort to buying, holding and collecting distributions.

Possible outperformance: Covered call ETFs can outperform in high-volatility, sideways trading markets, which helps maximize the premiums received and ensures a better chance of the calls sold expiring worthless out-of-the-money. 

Drawbacks of Covered Call ETFs

Covered call ETFs aren't money printers. Options strategies don't offer a free lunch – rather, they transform the risk/return profile of the underlying investment. In the case of covered call ETFs, some disadvantages include:

Downside risk: The premium received from a covered call ETF can cushion losses slightly, but investors are still mostly exposed to the full downside of a long equity position. If the underlying stocks in a covered call ETF crash, the premium received won't do much to hedge it. 

Possible underperformance: Covered call ETFs can underperform regular ETFs during low-volatility bull markets. In this case, there is a high chance of the calls sold expiring in the money. As a result, the ETF manager must sell the underlying shares at the strike price, foregoing higher gains than if they sold at the market price. This can cap the total return of the covered call ETF over time, causing it to underperform a regular long equity strategy. 

Higher fees: Because of the use of derivatives, a covered call ETF tends to charge a much higher expense ratio than that of regular index ETFs. Over time, high fees can compound and eat into long-term returns. Investors looking to prioritize low fees may find covered call ETFs too expensive for their needs. 

Compare ETF Brokers

Investors looking to research and choose the best covered call ETFs can use Benzinga to compare the available selections available on the market. Here is a list of brokers that support covered call ETF trading and offer research tools to help investors select the right one.

Frequently Asked Questions