How to Enhance Income Potential with Covered Call ETFs

Finding reliable income to complement a portfolio and risk profile can – at times – prove to be a difficult task. Options-based strategies can help generate income, manage risk, or both, depending on the objective.

Options strategies can help investors navigate a variety of market conditions or achieve certain outcomes like generating income or managing risk. Often, these strategies invest in specific assets, such as the stocks in an index, and implement some combination of buying or selling calls and puts on those same assets in an effort to achieve the desired outcome. ETFs investing in options can be an efficient tool for investors looking to incorporate these strategies in their portfolio.

Key Takeaways

• Covered call strategies can be an effective tool to enhance and diversify your income potential, particularly during times of uncertainty and market volatility.
• Covered calls are a sophisticated investment which, when done directly, require an understanding of derivatives trading and the ability to manage margin calls.
• Global X Nasdaq 100 Covered Call ETF (QYLD) and Global X S&P 500 Covered Call ETF (UYLD) provide Australian investors access to the largest covered call strategies in the world. AYLD offers unique access to covered calls on the S&P/ASX 200, offering an additional source of income on top of franking credits and dividends.

What are Covered Calls and Covered Call ETFs?

A covered call strategy involves buying a stock or basket of stocks and selling a call option on those securities. Selling a call option forfeits the upside potential on those underlying stocks if it’s written at-the-money (ATM). In exchange, the investor receives a premium for selling the call option. Therefore, a covered call strategy can be used to generate additional income from equities.

Covered Call Features

• Generates income based on premiums received from selling the call options.
• Upside potential is capped, while downside risk is mitigated to the extent of the option premiums received.
• Can generate higher income during volatile markets since option premiums are historically correlated to the underlying security’s implied volatility.
• Full coverage (100% covered) entails writing calls on 100% of the value of the underlying securities owned in the portfolio. A portfolio which is 100% covered maximises the premium income but forfeits all upside potential.

Covered Call ETFs

• Covered call ETFs are popular strategies and can save investors the time and some of the potential risks, like managing margin calls, of running covered call strategies directly.
• Whilst ETFs have management fees, there are still cost benefits that come with the scale at which the ETF runs compared to the brokerage and risk of individual management.
• Global X has been running ETF strategies globally for 10 years with a proven history of success. Our US-listed QYLD is the largest covered call ETF on the US market and broader covered call range has nearly AUD$25 billion in assets under management (AUM) as of January 2023.¹

 Why use Covered Call ETFs?

 Alternative and Diversified Income Source

Covered call strategies can help investors generate diversified income or balance objectives between growth and income, particularly in a rising rate environment.

These strategies also diversify an investor’s source of income away from just equities and bonds, which historically struggle in rising rate environments or times of volatility. Diversification across asset classes is important because simple diversification, such as the 60/40 portfolio split across equities and fixed income, may not meet investors’ specific income and growth needs.

Home bias is also inherent in many portfolios where the sector and stock allocations favour the largest companies like the banks and miners here in Australia. The dividends they pay are tied to their earnings which has the propensity to be volatile depending on economic conditions.

Covered calls helps diversify that income to be less tied to economic conditions, outside stock or market volatility, which see more consistent income throughout the year.

By using a covered call ETF, you can also smooth out the income profile of a portfolio with either monthly or quarterly distributions compared to many companies paying dividends semi-annually.

Offers a Buffer During Drawdowns

For many investors, such as retirees, protecting principal during market selloffs can be just as important as income generation. Covered call strategies, by taking in the premium of the sold call option, can help buffer downturns as the premiums provide an extra source of return. This is reflected in the graph below, which shows the lower drawdowns of covered call indexes.

However, this does come with a trade-off. In strong bull markets, due to covered calls capping the upside, the gains that could have been made over holding the underlying stock or index are limited.

How Covered Call Strategies Respond to Different Market Conditions

Down Market: In the example below, the Nasdaq 100 index ended the month below the strike price. So, QYLD which sold the call option would potentially benefit from the premium received. This may offset some or all of the decline in the underlying equity holdings.

Flat market: If the index price has not changed at the end of the month, QYLD keeps the money it collected from selling the monthly index call and the fund still owns the underlying equities.

Up market: If the index price rises at the end of the month, potential gain will be limited since the Fund sold a call option at a predefined strike price. As the index rises above the strike price, the fund still keeps the money collected from selling the monthly index call option, but will not benefit from the entire increase in the index value.

Global X Covered Call Strategies Deep Dive

Options strategies offer investors flexibility and the ability to shift market factor exposure, which can be particularly attractive during periods of macroeconomic uncertainty and market volatility. They can also offer a range of potential outcomes for investors, the mechanics of which we break down here.

At-The-Money (ATM) Covered Call Strategies: High Income Potential with Reduced Volatility

To begin we need a quick overview of some options language.

Global X covered call ETFs write calls ATM as this can be appealing to investors seeking income with the potential for reduced volatility in their equity exposure. For example, historically the Nasdaq 100 is more volatile than the S&P 500 due to overweights in growth sectors like technology and communication services, but the S&P 500 recently has been getting more volatile. The ability to collect premiums can potentially mitigate volatility in down markets.

Covered call strategies in ETFs consist of owning all the stocks in an index, like the S&P/ASX200 or S&P 500 and selling a call option on that same index. Covered call strategies utilised here are said to be 100% covered which means that the strategy is writing calls on 100% of the portfolio.

What the investor can expect in terms of premiums received depends on how much notional exposure the call option is written, and the moneyness of where it’s written—at the money (ATM), out of the money (OTM), or in the money (ITM).

Covered call strategies written ATM forfeit the upside potential in exchange for current income collected from the premiums received from writing the call option. As option premiums tend to rise in volatile markets, covered call strategies tend to perform better in volatile yet sideways markets than in major bull or bear markets.

Covered Calls can be Used Both Strategically and Tactically

For long term strategic investors covered call strategies may be helpful in market environments where income becomes scarce. Covered call strategies can produce high income while diversifying the source of risk in a portfolio as the calls are written on diversified indices such as the S&P/ASX200, the Nasdaq 100 or the S&P 500 as opposed to single company securities. They also help increase income certainty and consistency by paying either monthly or quarterly distributions.

Covered call strategies can be appropriate for tactical portfolios as well where making a call on market direction can either support or contradict covered call use. Underperformance will likely occur in a strong up market as the covered call strategy will forfeit the upside of the index held, only receiving the premium. Whereas in a flat market, the strategy will likely outperform due to the premiums received from selling call option while there is no lost opportunity cost of the underlying index rising. In a down market, the strategy may also outperform because they keep the premium received from selling the call option, which may offset some or all of the underlying market’s decline.

Considerations for Covered Call Investors

Before investing, investors should ensure they understand covered call option writing risk. By writing covered call options in return for the receipt of premiums, AYLD will give up the opportunity to benefit from potential increases in the value of the S&P/ASX 200 Index above the exercise prices of such options but will continue to bear the risk of declines in the value of the S&P/ASX 200 Index.

The premiums received from the options may not be sufficient to offset any losses sustained from the volatility of the underlying stocks over time. As a result, the risks associated with writing covered call options may be similar to the risks associated with writing put options. In addition, AYLD’s ability to sell the securities underlying the options will be limited while the options are in effect unless AYLD cancels out the option positions through the purchase of offsetting identical options prior to the expiration of the written options. Exchanges may suspend the trading of options in volatile markets. If trading is suspended, AYLD may be unable to write options at times that may be desirable or advantageous to do so, which may increase the risk of tracking error.

Making a Call on a Portfolio’s Income Potential

Options-based strategies can help investors navigate various market conditions, including the type of elevated rising interest rate and inflation-driven volatility in the market currently. These strategies can help investors achieve certain objectives like generating income or managing downside risk. For example, compared to traditional equity opportunities, certain option strategies can achieve a more efficient balance of income and growth and increase portfolio yield. Markets are variable, but certain options strategies, including those offered by Global X, could help provide investors some stability amid uncertainty.

Investors can consider using covered call strategies in a portfolio as:

• A core portfolio holding to replace a portion of US or Australian equity exposure, as the options premiums generated from selling calls can smooth drawdowns without deviating substantially from benchmark.
• A satellite providing an alternative source of income, especially in times of heightened volatility or rising interest rates.