- October 22, 2024
- Posted by: Mark Soberman
- Category: Trading Article
Covered call ETFs are rocket-hot right now.
Investors have been throwing billions of dollars of capital into these Income and growth-focused ETFs.
The big draw is the frequent income payments shareholders collect – dividends from writing call options on the overall portfolio.
While these Covered call ETFs are hot, they do have a number of tradeoffs. That’s what I’m going to discuss today. I hope this information helps you decide if covered call ETFs are right for your portfolio.
Let’s first start by getting on the same page…
What Are Covered Call ETFs?
A covered call ETF is an Exchange Traded Fund that holds a collection of stocks. However, unlike a traditional ETF that’s all about buy and hold… The covered call ETFs overlay an options strategy to generate income.
The fund simply sells call options against the stocks they hold.
When a call option is sold, the seller agrees to sell the underlying stock at a specified price (the strike price) if the stock reaches that price by a set expiration date. When they sell this right, the fund collects income (known as option premiums).
This income is then passed along to the ETF’s investors in the form of distributions or dividends.
It sounds amazing, but all strategies have their pros and cons…
Pros of Investing in Covered Call ETFs
There are 4 big reasons to own Covered Call ETFs:
=> Steady Income Streams
=> Reduced Volatility
=> Downside Protection
=> Diversification
Let’s look at each one of these in more detail…
Aspect | Pros |
---|---|
Income | – Steady income stream through option premiums – Higher yields than regular ETFs – Alternative to bonds in low-interest environments – Suitable for retirees and passive income seekers |
Volatility | – Reduced volatility compared to traditional stock ETFs – Income provides cushion against minor market declines |
Risk Management | – Partial downside protection – Premium income helps offset small losses |
Diversification | – Built-in diversification across multiple stocks – Adds options strategy to portfolio |
This table focuses on the key advantages of investing in Covered Call ETFs.
Steady Income Stream
One of the main reasons investors are attracted to covered call ETFs is the steady income they generate through option premiums.
Since these ETFs regularly sell call options they generate steady streams of cash week in and week out. This allows regular payments from the funds to shareholders. Sometimes their yields can be significantly higher than the regular ETFs – owning the exact same shares.
In low-interest-rate environments (Like we’re in right now), some investors use covered call ETFs as an alternative to bonds or even traditional dividend-paying stocks.
This income is perfect for Retirees, active traders, and investors seeking passive income.
Reduced Volatility
Covered call ETFs also tend to be less volatile than traditional stock-based ETFs.
The income generated by selling options provides a cushion that can soften the blow of minor market declines.
In times of market uncertainty, this stability can be a major plus for investors who prefer a smoother ride.
Downside Protection
While not a perfect shield, covered call ETFs provide some downside protection. The income earned from selling options acts as a partial hedge.
If the stock market falls, the premium collected from selling the call options helps reduce the overall losses.
While this doesn’t eliminate all risk, it mitigates the impact of smaller declines, making covered call ETFs appealing to investors who are looking for a bit more protection in their portfolio.
Diversification
Just like regular ETF, covered call ETFs offer built-in diversification by holding a basket of different stocks. This spreads out the risk, when compared to buying individual stocks.
The added layer of selling options provides further diversification by adding a different income-generating strategy to the portfolio.
Whether you’re holding a covered call ETF on a broad index like the S&P 500 or on a specific sector, you’re adding diversity not only in assets but also in investment approach.
While the pros to owning Covered Call ETFs are strong, there are a few Cons too.
Cons of Investing in Covered Call ETFs
Aspect | Cons |
---|---|
Upside Potential | – Limited potential for capital gains – Profit capped during strong market rallies – Less suitable for growth-oriented investors – Best performance in neutral or mildly bullish markets |
Market Vulnerability | – Not immune to sharp market declines – May experience significant losses in severe bear markets – Limited downside protection in market crashes |
Complexity | – More complex than traditional ETFs – Requires understanding of options trading strategies – Recommended to research before investing |
Liquidity | – Potentially lower liquidity than traditional ETFs – Wider bid-ask spreads, especially in smaller ETFs – Higher transaction costs when buying or selling shares |
Capped Upside Potential
The biggest trade-off when investing in covered call ETFs is the limited potential for upside gains.
Because these funds sell call options, they agree to sell the underlying stocks at a predetermined price.
If the market experiences a strong rally, and stock prices soar past the strike price, the fund must sell its holdings, capping its profit.
Essentially, while you’re earning income through premiums, you’re sacrificing potential gains during bullish markets.
For growth-oriented investors who are aiming for significant capital appreciation, this could be a significant downside. The strategy works best in neutral or mildly bullish markets where stocks don’t rise significantly beyond their strike prices.
Vulnerability to Sharp Market Declines
While covered call ETFs provide some protection in down markets, they aren’t immune to sharp declines. In a severe bear market, the premiums collected from selling options may not be enough to offset the losses in the stock portfolio.
During market crashes, covered call ETFs are expected to experience significant price declines.
Investors expecting sharp market corrections should be cautious, as the downside protection offered by these ETFs has its limits.
Complexity
Normally trading covered calls on your own, you’d want to have a working knowledge of how options premiums, strike prices, and expiration dates work.
Covered call ETFs are more complex than traditional ETFs. The nice thing is the fund managers are engaging in options trading strategies on top of stock ownership. They take on the complexity of the trades.
That said, I always encourage everyone to understand everything they can about their investments.
If you’re unfamiliar with options trading, it may be worth doing some research and learning about these options trading strategies – BEFORE you invest.
Lower Liquidity
Some covered call ETFs do not have the same level of liquidity as traditional ETFs. Often the smaller the ETF the lower the liquidity.
Lower trading volumes can make it harder to enter and exit positions quickly and at favorable prices.
You may find wider bid-ask spreads in these ETFs. That means higher transaction costs when buying or selling shares.
Key Considerations Before Investing in Covered Call ETFs
Regular “Stock Brokers” are going to say to be careful of Covered Call ETFs.
They love to use the phrase “consider your market outlook and investment goals, before investing.”
Are they wrong?
Nope.
But for smart investors who understand the markets, volatility, and risk… the supercharged payouts these Covered Call ETFs can make – put them head and shoulders above other investments.
These covered call ETFs are very valuable in neutral or moderately bullish markets… by generating steady income while managing risk.
If you’re interested in covered call ETFs, check out…
Five Popular Covered Call ETFs
The top 5 covered call ETFs – based on assets held are:
- JPMorgan Equity Premium Income ETF (JEPI)
- Global X NASDAQ 100 Covered Call ETF (QYLD)
- Global X S&P 500 Covered Call ETF (XYLD)
- Global X Russell 2000 Covered Call ETF (RYLD)
- YieldMax NVDA Option Income Strategy ETF (NVDY)
Each of these ETFs focuses on a different part of the market, and some use slightly different covered call strategies.
Every covered call ETF has tradeoffs. I suggest you give them a deep look, as their income generation may go a long way to bolster your investment returns.
Speaking of returns…
How to SUPERCHARGE Your ETF Portfolio
If you’re going to manage and supercharge your own ETF portfolio, I think you need to focus on both income and growth. But, not everyone knows how to do that in today’s crazy market.!
To help, we’ve decided to host a free webinar all about generating both PASSIVE INCOME and ACCOUNT GROWTH, in just minutes with covered call ETFs.
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We’ll be introducing “The ETF Income Accelerator: 5 Minutes to Weekly Payouts and Lasting Leveraged Growth”
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The workshop is October 30th, at NOON Eastern time / 9 AM Pacific time.
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