Covered Call ETFs: What They Are and a DIY Alternative

Covered Calls, Investing Strategies
covered call ETF: person typing with graphs on the screen

Options are often viewed as complicated derivatives that offer high risk, high reward. That’s true if you’re buying options. However, if you’re selling covered call options, you can also generate income with limited risk. And thanks to a plethora of exchange-traded funds, you don’t even have to trade options yourself.

In this article, we’ll explore what covered call options are, review covered call ETFs that offer this strategy, and outline a do-it-yourself alternative that could be even more profitable. 

Covered Call Strategy Basics 

A covered call option is a trading strategy where you write (i.e., sell) an option for the underlying security (usually a stock) that you hold. When you sell the option, you collect the premium from the option buyer. 

Then, when the expiration date approaches, two things could happen: 

  • If the stock price is below the strike price, the option expires out of the money, and as an options writer, you no longer have any obligation to sell the stock.
  • If the stock price is above the strike price, the option expires in the money and your stock is called to the buyer. 

As you can see, this strategy limits your potential upside from holding the stock but provides a guaranteed income in form of the option premium. Meanwhile, you still have the potential downside risk from holding the stock. 

Here is when this strategy is most profitable: 

  • The market or the stock is in a sideways trend, and you don’t expect strong upward moves, which means it’s less likely that the call option you wrote will expire in the money. 
  • The price volatility of the market or the underlying stock is rising, which makes all options more valuable, which means you can collect higher premiums for the calls you’re selling. 

Of course, there is no free money and writing covered calls comes with a catch. During strong bull markets, your stock would be called away, and you’ll miss out on the gains. The premium you collected likely won’t cover the foregone profit from simply holding a long position in the stock. 

This strategy is also fairly advanced for most individual investors. That’s why FINRA requires brokers to ensure that their clients have adequate experience and funds to sell options. But covered call clearance is the easiest to get.

Still, the idea of additional portfolio income from holding stocks is very appealing, and so many investors turn to ETFs that run this strategy. 

Covered Call ETFs

covered call ETF: pen crossing numbers on paper

A covered call ETF is an exchange-traded fund that holds some stocks and also writes call options for the same stock. These funds are also known as buy-write ETFs.

The pay-off of covered call ETFs is roughly the same as for the general covered call strategy that we’ve discussed. The difference is that you pay fees to the fund manager executing the strategy. 

The main advantage of covered call ETF is that it’s all done for you. You don’t have to pick expiration dates and strike prices or spend time selling new options after the previous ones expired. 

Additionally, buy-write ETFs could also increase the diversification of your portfolio. For example, option prices rise with market price volatility, which usually hurts energy and commodity stocks. 

This convenience and potential diversification come at a cost. Expense ratios for covered call ETFs are higher than for straightforward index funds. 

Popular Covered Call ETFs

Compared to other types of ETFs, there are relatively few funds that specialize in covered calls. Below are several popular funds to give you an example of what’s available. 

  • Global X NASDAQ 100 Covered Call ETF (NASDAQ:QYLD): QYLD is the largest buy-write ETF with $3.55 billion of net assets. QYLD tracks the Nasdaq-100 and writes calls for the index. Compared to regular Nasdaq-tracking ETFs, like QQQ, this fund offers more yield through income from option premiums and is usually less volatile. Yet in theory, QYLD also limits the upside from exposure to growth tech companies that make up the Nasdaq-100 Index because the assets would be called during strong bullish markets.
  • Global X S&P 500 Covered Call ETF (NYSEARCA:XYLD): XYLD is a fund that tracks the S&P 500 Index and writes one-month, at-the-money call options for up to 100% of the assets. The fund generates additional income on top of the dividend yield. Yet it also greatly limits the upside potential. As a result, XYLD’s returns differ from regular ETFs that track the S&P 500, which could be good for portfolio diversification. 
  • CBOE Vest S&P 500 Dividend Aristocrats Target Income ETF (BATS:KNG): KNG is a fund that holds Dividend Aristocrats, stocks that have track records of increasing dividends for at least 25 years. The fund boosts the yield by writing calls for up to 20% of the fund’s total assets. Because dividend stocks are usually mature companies with lower growth prospects, the buy-writing does not put as much drag on the upside potential. This ETF, however, has a higher expense ratio of 0.75%. 

When selecting an ETF you should take the time to read the full prospectus. Many investors simply focus on the expense ratio. Yet the prospectus could also include important clauses that modify the risk profile of the fund — for example, the use of leverage or the maximum overlay of call options (i.e., the share of assets that cover the call options).

Finally, covered call ETFs have relatively low market caps, which could limit their liquidity. The largest fund, QYLD, has only $3.5 billion assets under management — similar to a mid-cap company. Other funds are similar in size to small caps. This means bid-ask spreads could be higher than for larger ETFs, especially during times of crisis when many investors might try to exit.  

DIY Alternative: Write Covered Calls 

person checking their mobile phone while having coffee

It might be tempting for an individual investor to just delegate call writing to managers of an ETF. After all, these funds have attractive yields and do all the work. 

Yet this comes at a cost. ETFs’ annual fees of 0.6% to 0.75% might look small. But over time, the fees can compound and hinder the growth of your portfolio. 

Furthermore, covered call ETFs typically write options for indices, which forces you to make macro predictions about the stock market as a whole. This is arguably more difficult than following a handful of stocks. And if the market overall is bullish, it generally doesn’t make sense to write calls for broad indices. 

Yet in any market, there are some mispricings that open up opportunities for call option writing. 

The general idea is simple. If you already hold at least 100 shares of individual stocks, you can write calls. The strike price and expiry date would depend on your goals for the stock.

For example, some stocks experience higher volatility due to corporate events. This would make writing options more lucrative. If your stock gets called, in many cases you would be able to buy it back, even at a higher price — as the premium you’ve collected would give you some leeway. 

Alternatively, a stock could be blowing off tops, rapidly and irrationally rising in price on some hype. If you happen to hold that stock and consider selling at some price, you can generate additional yield through writing calls. If the strike price equals your target selling price, you wouldn’t mind the stock being called. 

So in many cases, writing calls yourself could be a great way to boost the total return of your portfolio. And every basis point that you save on ETF fees speeds up your journey toward your financial goals. 

You Don’t Have to Trade Alone

In this post, we’ve reviewed the general strategy of writing covered calls, reviewed popular covered call ETFs, and explored why you might consider doing your own buy-writing. 

This might be too advanced if you’re a new option trader, but with practice, you’ll get the hang of it. The good news is that you don’t need to take on big risks or do it alone. To learn how to trade options with the spare change you can find in your home, sign up for Investors Alley’s Option Floor Trader PRO.