Last updated on April 19th, 2022 , 01:00 pm
7 Best Covered Call ETFs and How They Work
The covered call strategy is a great way for risk-averse investors to make passive income in a sideways market.
For those who already have a solid understanding of how covered calls work, we have provided a list of some of the best covered call ETFs below.
For those who aren’t 100% certain about the mechanics of covered calls (each one is different!), please read on as understanding these various strategies is vital to understanding their performance.
Lastly, I would like to add that most covered call ETFs are NOT passive investments. The “set-it-and-forget-it” approach does not work here. Why?
Over time, covered call ETFs tend to massively underperform the market. If you are looking at a long time horizon (such as retirement), history tells us the best approach to investing in equities is outright. However, if your time horizon is relatively short, and you are either neutral or slightly bearish on the market, covered calls may provide a great way for you to make some extra money.
Without further ado, here’s our list! Remember, there is A LOT more to these ETFs than their dividend! A fat dividend usually coincides with forfeiture of price appreciation.
Please read on if you have any questions as they will most likely be answered.
7 Top Covered Call ETFs
| Ticker | Fund Name | Dividend Yield | Strategy | Option Strategy | Expense Ratio |
|---|---|---|---|---|---|
|
Global X S&P 500 Covered Call ETF |
9.12% |
Income |
Sells at-the-money calls
|
0.60%
|
|
|
Global X Nasdaq 100 Covered Call ETF
|
9.92% |
Income |
Sells at-the-money calls
|
0.60%
|
|
|
Global X Russell 2000 Covered Call ETF |
12.09% |
Income |
Sells at-the-money calls
|
0.60% |
|
|
Global X S&P 500 Covered Call & Growth ETF |
0.78% 30-day SEC Yield (new fund) |
Income + Price Appreciation |
Sells at-the-money calls on 50% of portfolio |
0.60%
|
|
|
Global X Nasdaq 100 Covered Call & Growth ETF |
0.08% 30-day SEC Yield (new fund) |
Income + Price Appreciation |
Sells at-the-money calls on 50% of portfolio |
0.60% |
|
|
X-Links™ Gold Shares Covered Call ETN |
9.77% |
Income + Price Appreciation |
Sells out-of-the-money calls |
0.65% |
|
|
FT Cboe Vest S&P 500® Dividend Aristocrats Target Income ETF |
3.40% |
Income + Price Appreciation |
Sells at-the-money calls on 20% of portfolio |
0.75% |
Want to skip over the covered calls tutorial and jump directly to an explanation of the above ETFs? Click Here!
Understanding Covered Calls for Beginners
The covered call option strategy is defined as the following:
Covered Call: A financial transaction where a call option is sold against an underlying security, typically 100 shares of stock.
Components:
- Long 100 Shares of Stock
- Short 1 Call Option
For a complete lesson on covered calls, please make sure to check out either our video or article on the subject.
Covered Call Example
In order to understand the utility of covered calls, let’s take a look at a quick example.
Let’s say you own 100 shares of Invesco’s QQQ ETF, which represents the Nasdaq 100.
In this scenario, let’s assume QQQ has been reaching all-time highs every day. You think the ETF is in for a breather and will trade sideways for some time. The current price of QQQ is $375/share.
With stock, there is no way you can capitalize off of your projected market direction. However, if you utilize options, you can make a little extra money off of a neutral share price. How?
By selling a call. Let’s say that you do not believe QQQ is going to trade above $380/share for the next month. In this situation, you could sell a call option 30 days out at the 380 strike price. We’ll say you are able to sell it for $2.
What does that mean? As long as QQQ is trading below $380/share when your option expires, you’ll receive the full credit of $2, or $200. However, if the ETF rallies to, let’s say, $390/share, you will miss out on this price appreciation.
When you sell a call against your stock, the most you can ever make is strike price + premium sold. In our case, once the stock goes above (380+2) $382/share, we won’t see any additional gain. For every dollar we make on the stock at these levels, we lose a dollar on the option.
Covered Call "Moneyness"
Covered calls can either be sold out-of-the-money, at-the-money, or in-the-money. In our above examples, all covered calls are sold at-the-money, or out-of-the-money (the traditional covered approach).
The “moneyness” of an option is determined by the strike price of that option relative to the stock price.
- An option is out-of-the-money if the strike price is above the stock price
- An option is at-the-money if the strike price is at (or near) the stock price
- An option is in-the-money if the strike price is below the stock price
Here’s how that looks on a chart:
Covered Call Performance
Markets will always be in one of three states: bearish, neutral, or bullish. The covered call strategy will profit in 2 (and sometimes 3!) of these markets.
1. Covered Call in a Bullish Market
Covered calls typically do not fare too well in a bullish market. This depends, of course, on the strike price of the call sold! If you sell an at-the-money option, you will likely miss out on price appreciation if the underlying rallies. If you sell an out-of-the-money option, and the stock doesn’t reach the strike price of the call you sold, you will win on both the income received as well as price appreciation!
2. Covered Call in a Neutral Market
Covered calls love neutral markets. In this scenario, you won’t miss out on any price appreciation. While everybody else is flat, you’ll be making a nice dividend!
3. Covered Call in a Bearish Market
Like covered calls in a bullish market, what really dictates how well a covered performs in a bear market depends on how bearish that market is.
For a minorly bearish market, the call we sell provides us some downside protection. Just subtract the premium you received from the stock price, and that’s where your losses begin to build up.
In a market correction, however, watch out! Though covered calls mitigate risk, they by no means irradicate risk; you still have A LOT of downside risk!
Let’s next look at a few pros and cons of covered call exchange-traded funds (ETFs).
Covered Call ETF Pros
1.) Income Generation
Selling a call option against your long stock creates a steady stream of income for your portfolio. Generally, covered call ETFs pay out dividends on a monthly basis, as that is the frequency that they sell calls.
The further out of the money the call you sell is, the less premium you will receive. Some covered call ETFs, like QYLD, sell at-the-money calls. That is the reason their dividend is so high. But remember, the closer the strike price is to the stock price, the less you’ll make when the stock rallies.
2.) Profit in a sideways market
With markets teetering near all-time highs, many investors believe we are in for a breather. The covered call strategy allows you to capitalize in a neutral market. If the market goes nowhere, you will collect the full premium on the call you sold.
3.) Covered Call ETFs may save time and money
Trading options is a very complex and time-consuming process. After working as an options broker in Chicago for 15 years, I can tell you that the education never stops. Investing in covered call ETFs gives you peace of mind; you don’t have to worry about “rolling” positions, nor do you have to worry about whether or not you are assigned.
ETFs employ “price stabilizers” to keep the ETF price in check, as well as fund managers to actively manage the positions. This does, however, come at a fee – most covered call ETFs I have seen charge a fee of about 0.60%. Though high when compared to other ETFs (the popular SPY ETF fee is only 0.09%), these funds certainly earn their money. Remember, trading options can be a costly endeavor in terms of time and commissions.
4.) Covered Call ETFs allow for great diversification.
A lot of the funds on our list go out and actually buy all of the securities within the index. That’s a lot of work! Can you imagine how much it would cost to buy all of the stocks within the Nasdaq 100 on your own?
5.) Covered Call ETFs have no assignment risk
When you are trading covered calls on your own, you are at risk of being assigned on your short call at times when the extrinsic value is low, or when the underlying issues a dividend (dividend risk). ETF managers take care of this for you, mostly by selling capitalize in a neutral market (European style options) which have no early-assignment risk as opposed to options on traditional stocks and ETFs (American style options).
Covered Call ETF Cons
1.) Upside limited to strike price + premium sold
Covered calls are not great investments for bullish markets. That is assuming an alternative for your investment strategy was to invest directly in the stock. After the stock surges beyond your strike price + premium sold, you will see no additional profit.
2.) Covered calls have massive stock risk
Though the covered call strategy does indeed limit the risk of an equity position, it by no means eradicates that risk. After you account for the discount of the premium you sold, a covered call loses money on a 1:1 basis with the stock.
3.) Poor performance in volatile sectors
The more volatile the underlying, the higher the dividend you will receive. But trading covered calls in very volatile sectors, such as energy, can wipe your account out. How?
Let’s say oil is trading at $100 a barrel and you own an ETF that matches this price, meaning the ETF tracks oil and is currently trading at $100/share. Let’s say oil plummets to $20/barrel. If you took in $5 for an at-the-money-call when the stock was at $100, your max loss would be $95/share. Your at-risk expose is still $95/share!
But that’s ok, because when oil rallies, you’ll be included in it, right? Nope. If you’re trading a covered call on oil, your upside IS LIMITED TO STRIKE PRICE PLUS PREMIUM.
Take a look at how Credit Suisse X Links Crude Oil Shares Covered Call ETN USOI (blue line) compares to a non-covered oil ETF (orange line). Remember, this chart doesn’t account for USOI’s fat dividends, but if you wanted to be long oil, you would have surely missed out!
XLYD, QYLD and RYLD ETFs Explained
The covered call ETF’s XLYD, QYLD, and RYLD (offered by Global X) all employ selling an at-the-money call representing 100% of their underlying portfolios. Respectively, they track the S&P 500, the Nasdaq 100, and the Russell 2000.
The closer your call is to being in-the-money, the more premium you will receive. It is because of this these three ETFs all have the highest dividends on our list.
But remember! When you sell at-the-money calls, you don’t participate in much price appreciation. And following a market crash, it may take a very long time indeed for your share price to play catch up.
For example, all markets crashed when the pandemic hit, but the Nasdaq soared on the tail of Covid. When you sell a covered call, however, your upside is limited to the premium received. This means that the QYLD fund participated very little in Nasdaq’s rally, as illustrated in the below 3-year chart comparing QYLD (purple) to its benchmark, the Nasdaq, as represented by QQQ (orange line).
The above chart represents the downside to covered call ETFs. There is, however, a pretty great upside. In an environment where the stock is stagnating, you’ll still be making a nice fat dividend. These three ETFs pay between 9 and 12% annually!
XLYG and QYLG ETFs Explained
XLYG and QYLG are two relatively new funds offered by Global X. Their representative indexes are the S&P 500 and the Nasdaq 100, respectively.
Similar to XLYD, QYLD, and RYLD, these funds sell one-month at-the-money calls on their indexes. However, there is one huge difference – XLYG and QYLG only sell these calls on 50% of their stock.
What does that mean? It means the other half of the equity is free to run higher (and lower) with the stock.
Since we are only selling calls on half of our positions here, it makes sense that the dividends for these two ETFs are lower.
GLDI ETF Explained
The GLDI ETF (offered by Credit Suisse X-Links) implements a covered call investment strategy in gold through the GLD ETF, which tracks the price of gold.
This fund offers investors who are neutral to minorly bearish in gold a great way to make a little extra income. I say minorly bullish because the fund sells calls that are 3% out-of-the-money on a monthly basis. This means the ETF can run 3% higher before we start missing out on price appreciation.
What is attractive here is the high dividend yield of 9.77%. Most of our other funds receive this kind of yield from selling at-the-money calls. But remember, gold is a lot more volatile than the S&P 500! The premium here is justified by the volatility in the underlying.
KNG ETF Explained
Last on our list is the KNG ETF, offered by First Trust. This fund tracks the S&P 500 Dividend Aristocrats Target Income Index.
Like XLYG and QYLG, this ETF is a hybrid fund. Here’s how First Trust describes its fund:
Perhaps most important is the low option exposure this ETF has: covered calls are written on a notional value of no more than 20% of the value of each underlying Aristocrat Stock.
This low covered call exposure is the reason for its relatively low dividend yield of 3.40%. This is a great ETF for minorly bullish investors on the S&P 500 Dividend Aristocrats Index.
- Note! The S&P 500 Dividend Aristocrats Index measures the performance of S&P 500 companies that have increased dividends each year for the past 25 consecutive years.
Final Word
So what do we take away from all of this? ETFs are a great way for novice and advanced traders alike to participate in the covered call strategy. There are downsides as well as upsides. It is not free money; you are giving up A LOT when you decide to invest in a covered call ETF. Having a solid grasp of how options work is a prerequisite.
Check out some of our recommended reading if you’d like to learn more about options trading!
What are your thoughts on covered call ETFs? Are they worth it? Let me know in the box at the bottom of this page!
Recommended Reading
- Covered Calls Explained
- How to Manage Covered Calls
- Option Trading for Beginners
Do you think covered call ETFs are a good fit for retirement accounts?
Hey Ted!
Covered call ETFs are generally not the best products for retirement accounts – at least for those with several years until they retire. Why? These funds are costly, often 5x more expensive than an index-tracking ETF would be. Additionally, covered call ETFs don’t recover as fast from market downturns as index-tracking ETFs do – that short call really limits upside price appreciation! These ETFs are best for relatively active investors. Hope this helps!