Covered call ETFs: How did they perform in the 2022 bear market?

How covered calls work

Covered call ETFs generate income by selling (writing) call options on increments of 100 shares of their underlying holdings. For example, a covered call ETF that tracks the S&P 500 will sell one call option for every 100 shares of the underlying S&P 500 ETF it holds. 

By selling this call option, the ETF earns an immediate cash premium, the amount of which is dependent on a few variables. Without getting into the complicated options math, the simple explanation is:

• Implied volatility: options premiums are higher when the implied volatility of the underlying asset is higher than historical averages. 
• Moneyness: options premiums are higher when the strike price of the call option sold is the same as the price of the underlying (at-the-money) or lower (in-the-money) as opposed to being higher (out-of-the-money). 
• Expiry date: options premiums are higher when the expiry date of the call option sold is dated further out in time. 

Depending on how the underlying asset performs, there are generally a few scenarios:

• The option expires out-of-the-money as the price of the underlying is below the strike price at expiry. The options seller keeps the premium and their 100 shares.
• The option expires out of the money as the price of the underlying has fallen far below the strike price at expiry. The options seller keeps the premium and their 100 shares, but incurs an unrealized loss on the 100 shares. 
• The option expires in the money as the price of the underlying has risen above the strike price at expiry. The options seller keeps the premium but must sell their 100 shares at the strike, which can cause them to forgo greater gains by selling the shares at the current market price. 

Investors can write calls on ETFs themselves. Earlier, I went over a few ETFs with well-developed options chains suitable for this. However, this approach can be complicated and time consuming, hence why it makes sense to pay a manager like Global X an expense ratio to do it professionally on your behalf. 

When covered calls outperform

Putting the above together, it's obvious that covered call strategies have the greatest chance of outperforming in high-volatility, sideways or bearish markets. 

Under these conditions, options premiums are enhanced due to the higher implied volatility that affects their pricing. Sideways or bearish price movements also help the option expire out of the money.

The net result is that under these conditions, covered call funds suffer lower maximum drawdowns and incur less volatility due to the premium acting as a buffer of sorts. Let's compare three Global X covered call ETFs to their index ETF counterparts in 2022 to see this in action.

First up is the Global X S&P 500 Covered Call ETF (XYLD) versus the SPDR S&P 500 ETF Trust (SPY):

Next up is the Global X NASDAQ 100 Covered Call ETF (QYLD) versus the Invesco QQQ ETF (QQQ):

Finally, the Global X Russell 2000 Covered Call ETF (RYLD) versus the iShares Russell 2000 ETF (IWM):

All three covered call ETFs strongly outperformed their index counterparts in 2022. Will this continue moving forward? I don't have a crystal ball, but it's worth noting that covered call ETFs would have been an excellent holding during the "lost decade" of 2000 – 2009 where the S&P 500 saw a flat -1.01% annualized return. It all depends on your thesis for how long the 2022 bear market will continue.

Please note this article is for information purposes only and does not constitute investment advice.