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A covered call ETF is an exchange-traded fund that generates potential income by writing call options on the securities the ETF holds. These actively-managed ETFs give investors the opportunity to benefit from covered call writing without having to participate in the options market directly.
Covered call ETFs allow investors to earn income in the form of options contract premiums, in addition to any other dividends, and potentially reduce portfolio volatility. One trade-off is that upside potential may be limited if call options are exercised — typically when the underlying security reaches the strike price — which could result in shares being called away from the fund.
Key Points
• A covered call ETF uses options writing to generate income from owned equities.
• Pros include potential for extra income and reduced volatility.
• Cons include the possibility of limited upside and higher fees vs. index-tracking ETFs.
• Covered call ETFs may suit income-focused investors, particularly in flat markets.
• These ETFs typically underperform during strong bull runs due to capped gains from the covered calls.
Basics of the Covered Call Strategy
Covered calls involve buying shares of a stock and then writing call options contracts on some of those shares. A covered call is also a type of “call writing” or “writing a call option” on a security.
Other investors can then purchase the call option contract. They pay a set fee to the call writer, known as the option’s premium, for doing so. The contract gives a buyer of the option the right, but not the obligation, to buy shares at a specific price on or before a specified date (known as the expiration date).
In the case of call options, when the share price of the underlying security rises above the strike price, an option holder can choose to exercise the option, at which point the stock may be called away from the shareholder who wrote the call option.
The option holder receives shares at a cost lower than the market value. Their profits may equal the difference between the option strike price and where the stock is currently trading minus the premium paid. The higher the stock price rises before the expiry date, the greater the potential profit for the person holding the call option.
Because the writer of the covered call option receives income on the deal in the form of a premium, they typically want the stock price to stay flat, fall, or rise only slightly. If the stock rises beyond the strike price of the option, then they’ll receive the premium, but their shares may be called away. The option writer could have a gain or loss depending on the difference between the option’s exercise price and the purchase price of the stock and the premium received.
On the other hand, if the stock doesn’t reach the strike price of the option, then the writer keeps both the premium and the shares. They’re then able to repeat the process depending on market conditions.
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What Is a Covered Call ETF?
A covered call ETF is an actively-managed exchange-traded fund (ETF) that buys a set of stocks and writes call options on them — engaging in the call-writing process with the goal of generating income through option premiums.
By investing in a covered call ETF, investors have the opportunity to gain exposure to covered calls without directly participating in options trading on their own. The fund takes care of the covered calls for them.
The ETF covered call strategy usually involves writing short-term (under two-month expiry) calls that are out-of-the-money (OTM), meaning the security’s price is below a call option’s strike price. Using shorter-term options enables the strategy to try to benefit from rapid time decay.
Options like these also serve to create a balance between earning relatively high premium payments while increasing the odds that the contracts will expire OTM (which, for covered call writers, is a positive outcome).
Writing options OTM serves to help ensure that investors may retain exposure to some amount of the upward price potential of the underlying securities.
When to Buy a Covered Call ETF
It may be a good time to consider buying a covered call ETF when most of the securities held by the ETF are expected to trade sideways or go down slightly for some time. Some investors may find covered call ETFs appealing if they are comfortable trading off potential outsized gains during rallies for near-term income.
Covered call ETFs might also be attractive to those with lower risk tolerance looking to add some potential additional income to their portfolio without having to learn how to write and trade options.
It’s important to know, however, that the focus and performance may vary significantly between different covered call ETFs. Many track index funds, such as the S&P 500, while others may track individual stocks and different funds may employ different call trading strategies. It’s important to research performance and identify funds that align with your risk tolerance.
When Not to Buy a Covered Call ETF
A time when it’s generally not advisable to buy a covered call ETF may be when stocks are rising and making new record highs on a regular basis. This is a scenario where covered call ETFs may underperform the rest of the market.
If the underlying securities rise only slightly, and do not exceed the strike prices set for the covered calls, then these ETFs may also perform well. It’s when stocks rise to the point that the shares get called away from the fund that the fund may underperform compared to holding shares directly.
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Pros and Cons of a Covered Call ETF
The main benefits that come from using an ETF covered call strategy are the potential for reduced risk and increased income.
Pros of a Covered Call ETF
Covered call ETFs may appeal to investors seeking enhanced yield, reduced volatility, and more stable long-term returns, though returns may lag during strong bull markets.
Some investors view these ETFs as a way to pursue income while smoothing returns in choppy or rangebound markets. While writing covered calls may help buffer some downside, these ETFs do not eliminate loss risk, particularly during sharp drawdowns or rallies that force shares to be called away.
Cons of a Covered Call ETF
Covered call ETFs are actively managed, which means they tend to have higher expense ratios than passively managed ETFs that track an index. These ETFs may also come with opportunity cost, since writing covered calls can cap upside potential in a bull market when market prices are spiking.
Covered call ETFs also carry both market and options risk. However, the income from options premiums may help offset those costs.
The Takeaway
A covered call ETF is an actively managed exchange-traded fund that provides exposure to the possible benefits of writing call options on stocks, without investors having to participate directly in the options market. For investors looking for a simpler approach, this may be a way to see income without managing options directly. Covered call ETFs have two primary features in the potential for reduced volatility and increased income.
That’s not to say that they don’t have downsides, too. Notably, they tend to be actively-managed, which generally means they have higher associated fees. Again, all of this should be taken into consideration before integrating any type of security into an investment strategy.
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FAQ
Is a covered call ETF a good investment?
It depends on the investor’s goals. Covered call ETFs may be attractive to those seeking income and lower volatility, especially in flat or slightly rising markets. However, they typically underperform in strong bull markets due to capped upside.
Why would someone buy a covered call ETF?
Investors may consider covered call ETFs to generate income from option premiums without managing options themselves. These funds can also reduce volatility, making them appealing to more conservative or income-focused investors.
What is the risk of a covered call?
The main risks include limited upside if the underlying stock rises sharply and potential losses if the stock declines. While the option premium can help provide limited downside protection or partially offset losses, covered calls still carry downside risk and may underperform in bull markets.
How often do covered call ETFs pay income?
Most covered call ETFs distribute income monthly, though payment schedules vary by fund. The income comes from the premiums collected by selling call options, which may fluctuate based on market conditions and the fund’s strategy, and may come from regular dividends as well.
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