QYLD: Exploring the Nasdaq 100 Covered Call Strategy

At the onset of 2023, a combination of factors dampened investor sentiment toward US equities. Among them, rising interest rates and recessionary concerns dented consumer confidence. However, as the first half unfolded, markets found support in the form of decelerating inflation, resilience in jobs reports, and strong positive revenue revisions for major players in the tech space. The rally was driven by a small constituency of mega-cap names in the Nasdaq 100 Index. Now that share gains have grown more broad-based, investors may be wondering where the markets will go looking forward. In this environment of higher valuations, covered call strategies can provide investors with the opportunity to hedge positions and generate current income. For instance, the Global X Nasdaq 100 Covered Call ETF (ASX: QYLD).

Key Takeaways

The Nasdaq 100 Index has increased precipitously in value so far this year, but momentum has slowed in recent months, and investors may be looking for a way to hedge their positions.
The Global X Nasdaq 100 Covered Call ETF (ASX: QYLD) is a fully covered buy-write strategy that uses the Nasdaq 100 as its reference asset. QYLD seeks to provide a stream of premium income and act as a competitive total return solution that may boost a portfolio’s current yield.
Covered call investment strategies can bring visibility, diversification benefits, and risk mitigation potential to a portfolio.

Finding Income in the Nasdaq 100

Despite market uncertainty this year to date, portfolios that maintained a healthy exposure to Nasdaq 100 Index constituents were well rewarded in the first half. The communication services, consumer discretionary, and information technology sectors, which make up the lion’s share of the index, represented some of the strongest performing segments of the market. In fact, a few participants in these growth focused arenas performed so well that it led to overconcentration in the index and a special rebalance in July, though the Nasdaq 100’s composition remains largely the same.

Major advancements in artificial intelligence, cloud computing, and the internet of things offer the potential to push valuations even higher. That said, some investors may be interested in hedging their positions, and they can do so while pursuing a source of current income through a covered call strategy. In the chart below, we highlight some of the more conventional asset classes investors use to find current yield. We also include the 12-month trailing yield provided by the Global X Nasdaq 100 Covered Call ETF (ASX: QYLD). Discounting the competitive income stream it has provided, the fund also offers exposure to the Nasdaq 100.

Duplicating exposures to Nasdaq 100 constituents might seem counterintuitive at first glance when trying to mitigate risk. However, an at-the-money covered call strategy like QYLD seeks to monetise the index’s volatility to create income that can act as somewhat of a hedge. That potential income can also supplement an existing growth strategy, allowing portfolios to have a positive relationship with volatility unlike that of other investment vehicles.

^{Performance data quoted represents past performance and does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when sold or redeemed, may be worth more or less than their original cost. Current performance may be higher or lower than the performance quoted.}

Breaking Down QYLD’s Basics

The Global X Nasdaq 100 Covered Call ETF is an index fund that operates on a rules-based policy, including a covered call option overlay. QYLD works in the same way as an individual investor writing covered calls to generate income. The difference being where an individual investor might write calls on a single equity, QYLD uses the broader Nasdaq 100 Index as its reference asset and writes its call options against the broader index. For more on how covered calls work, read our insight blog here.

Rather than purchase an ETF that tracks the Nasdaq 100, QYLD purchases the many individual components that comprise the index. As a result, the fund can maintain a high level of liquidity and is not subject to the additional expenses that might be associated with purchasing another ETF. Also, the strategy keeps the fund flexible in that it can purchase or sell the stock of individual companies in order to maintain an overall weighting that is as close as possible to its equity index, the Nasdaq 100. QYLD seeks to provide investment results that correspond generally to the price and yield performance, before fees and expenses, of the Cboe Nasdaq 100 BuyWrite V2 Index.

QYLD operates a call-write strategy to cover 100% of its notional portfolio by selling Nasdaq 100 (NDX) call options that cover the entire Nasdaq 100, as opposed to writing call options on all the stocks that make up the index individually. The fund uses European-style options that cannot be executed by the purchaser until the contract reaches its expiration date. These contracts are cash settled, so the fund maintains its systematic approach, writing at-the-money options monthly, and investors do not need to be concerned with how the fund can maintain its holdings at a similar weight to the index.

Each month, the Global X Nasdaq 100 Covered Call ETF writes call options with strike prices that are at-the-money, which means at initiation the strike price of the calls written is equal to the value of the underlying index. If a contract with a strike price that is precisely at-the-money is not available to be sold, the fund will write its call options at the closest possible strike price to the reference index’s value that is out of the money. The strategy allows the fund to attract the highest possible premiums for its written calls without selling contracts that are already in a position to potentially be exercised. From there, the fund proceeds to implement its distribution policy of distributing half of the premiums it has received or 1% of the fund’s net asset value, whichever is lower. The balance of the premium is reinvested back into the fund.

QYLD Represents a Total Return Solution

Writing index call options against 100% of the value of its portfolio, QYLD forgoes the possibility of realising the full capital appreciation generated by the Nasdaq 100 Index. The fund operates this way so it can attract the highest possible premiums in exchange for calls written. It then makes its distributions from this stockpile in an effort to produce a competitive yield.

Investors can use the income that may be generated by a position in QYLD at their discretion. That said, this income is oftentimes absent from the fund’s price chart when displayed across various investment research platforms. This undertaking results in QYLD displaying a negative price trend since its inception, as shown in the chart below. However, depending on their needs, we encourage investors to consider the opportunity for reinvestment that exists as a product of the income that QYLD has generated. Indeed, we view QYLD as a total return solution and submit its performance should be assessed as such. If held since inception and with all distributions reinvested into the fund, an investor’s cumulative total return for QYLD would have been about 95% as of August 31^st2023.²

^{Past performance is not a guarantee of future results.}

A natural question is how the fund can maintain recent price levels or recuperate its NAV after distributions. First, the fund reinvests the balance of the premiums that are not distributed to its shareholders. Second, new shareholders can help buoy the fund’s stockpile of assets. Third, the fund can derive value from the options it writes, benefiting from changes in underlying time value.

For instance, when QYLD commences a monthly roll period, it writes a call contract that will fluctuate in value until expiration. These fluctuations take moneyness, volatility, and supply and demand into account. If the initial contract was written when volatility was elevated, and then volatility declined, the value of the call option written generally decreases in a similar fashion over the course of the roll period. Writing this call option for a value that was higher than its realised value at expiration benefits the fund, as the option expires unexercised, creating an inverse relationship between NAV and volatility.

Based on the fund’s trailing 12-month yield of 11.89%, QYLD has shown it can remain competitive versus other asset classes from an income perspective even amid a period of declining volatility such as this.³ The income component may suit the needs of various accounts, including retail investors on the cusp of retirement or institutional cases like pension funds and endowments. That said, writing call options against 100% of an underlying portfolio can affect a fund’s performance in varying market scenarios. In theory, the premiums QYLD receives position it to outperform the Nasdaq 100 most effectively when the index trades in choppy, flat, and declining directions.

Covered Call Strategies Can Help Investors Round Out Their Portfolios

Investors can pursue wealth generation in many ways, beyond traditional allocations like the 60/40 equity and fixed income structure. A strategy like QYLD can offer investors a potential stream of current income and a diverse group of holdings on which to base its risk-adjusted returns. With a portfolio that follows the rules set forth by the Cboe Nasdaq 100 BuyWrite v2 Index and daily disclosure of portfolio holdings, QYLD also allows investors to be fully aware of the fund’s exposures. The fund trades the upside potential associated with its reference equity index to create premium income, so it may also act as a functional portfolio diversifier and hedged equity solution on multiple levels.

Diversification Potential

Operating within the ETF sleeve, covered call option strategies like QYLD have the potential to reduce the beta coefficient associated with a basket of investments like the Nasdaq 100. Index funds can inherently provide this because they typically take positions on a broad base of assets. With more than US$327 billion in global ETF and mutual fund assets that can be linked to it, the Nasdaq 100 is a popular destination for investors pursuing this exposure.⁴

When it comes to conventional income accounts that have more of a tendency to seek out high dividend-paying stocks, as the chart below shows, QYLD offers allocations toward sectors that might have previously been deemed unsuitable. By seeking to monetise the volatility associated with these sectors, QYLD’s ability to acquire premium income creates an opportunity to pursue these underexposed positions.

Visibility and Risk Mitigation Potential

Another key attribute associated with systematic covered call funds like QYLD is their straightforward, rules-based nature. Passively managed products typically follow a strict set of rules that establish specific exposures over an explicit time frame. Relative to a strategy that employs active management without daily holdings disclosure, this might empower investors to gain a better understanding of precisely where fund allocations are being made. The uniformity of a rules-based investment strategy can allow for seamless implementation into a broader portfolio, where risk-adjusted return metrics can be considered and weighed accordingly. It can also help to save the time researching more complex strategies can require.

Ability to Work Within an Equity Growth Portfolio

Because QYLD seeks a minimal level of capital appreciation in exchange for option premiums, the fund offers a value proposition that can be utilised through various allocation combinations. For example, an investor may be able to implement QYLD within a broader growth portfolio as a means to obtain a growth and income blend, depending on their risk and yield appetite. The ability to be this nimble within an index tracking strategy that maintains a 100% coverage ratio with NDX call options can support an investor’s ability to modify their respective portfolios in a variety of different ways. Some examples of equity portfolio breakdowns harness QYLD are illustrated below.

^{QYLD returns are represented by NAV returns. Beta is measured against the Nasdaq-100 Index.}^{The performance data quoted represents past performance. Past performance does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when sold or redeemed, may be worth more or less than their original cost and current performance may be lower or higher than the performance quoted.}

Conclusion: A Multipurpose Premium Income Solution Amid Uncertainty

Mixed economic signals, including those from corporate earnings and treasury yields, make speculating on future market movements particularly difficult. This year’s rapid run-up in value for the Nasdaq 100 and its subsequent slowing hasn’t made it any easier. In this environment, covered call options strategies can bring a multitude of benefits to investor portfolios, particularly when volatility ramps up and uncertainties linger. As a core competency of the ETFs that Global X provides, we believe that QYLD’s systematic approach makes it a compelling income-generating diversification tool for a broad range of accounts.

Footnotes

The Fund typically earns income dividends from stocks and options premiums. These amounts, net of expenses, are typically passed along to shareholders as dividends from net investment income. The Fund realises capital gains from writing options and capital gains or losses whenever it sells securities. Any net realised long-term capital gains are distributed to shareholders as “capital gain distributions.’’ The Fund collects dividends from their equity companies and monthly options premium from selling monthly call options in which portions have been passed to shareholders as monthly distributions. A portion of the distribution may include a return of capital. These do not imply rates for any future distributions.
Bloomberg L.P. (n.d.) [Global X Nasdaq 100 Covered Call ETF (QYLD) total returns from December 12, 2013 to August 31, 2023] [Data Set]. Retrieved on September 12, 2023 from Global X Bloomberg terminal.
Global X ETFs. (2023, July 31). Global X Nasdaq 100 Covered Call ETF (QYLD) Fact Sheet.
Morningstar Direct. Measured June 30^th, 2023 through Global X’s Morningstar Direct License.

Glossary

Call Option: A call option gives the buyer the right, but not the obligation to buy a security at a pre-determined strike price within a given time frame or on a specific date.

Covered Call: A covered call (call write) strategy involves purchasing securities, such as equities, and then simultaneously selling a call option on those securities.

12-Month Yield: A calculation that divides a fund’s cumulative distributions over the trailing 12-month period by its net asset value at the end of the period to determine a yield associated with holding a position in the fund over that time frame.

Yield to Worst: A measure of the lowest possible yield that can be received by a bond that could potentially possess an early retirement provision.

Out of the Money (OTM): An option is considered to be out-of-the-money when the price of its underlying asset has not yet surpassed the strike price necessary for it to become exercisable.

S&P 500 Index: The S&P 500 Index includes 500 of the largest public companies listed on the stock market.

Downside Volatility: A measure of downside risk that focuses on returns that fall below the average annual return related to an associated investment. Calculated by taking the standard deviation of returns that are below the mean return of a broader portfolio.

Nasdaq 100 Index: The NASDAQ 100 index includes 100 of the largest non-financial companies listed on its stock market.

Beta: Measures the volatility of a fund’s price relative to the volatility in the market index and can also be identified as the percentage change in the price of the fund given a 1% change in the market index. A beta below one suggests that the fund was less volatile than the market benchmark.

At-the-money: An option contract is considered to be “At the Money” when its strike price is equivalent to the current price value of its underlying asset.