Options Strategies in ETFs, Part 2: Covered Call ETFs

How the covered call strategy works

A covered call is an options strategy employed by investors aiming to generate additional income from their stock holdings, especially in flat markets. At its core, the strategy involves holding a stock (or ETF) and selling a call option on that same stock.

The call option grants the buyer the right, but not the obligation, to purchase the stock at a specified price (known as the strike price) before the option's expiration date. In exchange for selling this right, the option writer (the seller) receives a cash premium.

Let's consider an investor who owns 100 shares of Company XYZ, currently trading at $50. Believing that the stock might not rise significantly in the short term, the investor decides to write a covered call with a strike price of $55, expiring in one month, for which they receive a premium of $2 per share.

There are three payout scenarios for this investor:

1. Stock rises to $60: The call option will be exercised. The investor sells the 100 shares for the strike price of $55, missing out on the additional appreciation from $55 to $60. However, they still keep the $2 premium, resulting in a profit of $7 per share ($5 appreciation + $2 premium).
2. Stock remains at $50: The call option expires worthless. The investor retains the stock and the $2 premium, effectively earning a $2 per share profit for the month.
3. Stock falls to $45: While the stock has depreciated, the loss is offset by the premium received. The net loss is $3 per share ($5 depreciation - $2 premium).

Now, the size of the premium received for selling this call is affected by three main variables:

1. Volatility of the Stock: Stocks with higher volatility generally have higher option premiums since they present a greater potential for price movement.
2. Time to Expiration: Options with longer durations usually have higher premiums as there's more time for the stock to move.
3. Strike Price: Options with strike prices closer to the current stock price (at-the-money options) typically have higher premiums compared to those significantly above (out-of-the-money) or below (in-the-money) the stock price.

In essence, by adopting a covered call strategy, an investor trades off potential future upside beyond the strike price for an immediate payout in the form of the option premium. You receive present income and some downside cushion but at the cost of capping upside return potential.

Covered call strategy implementation in ETFs

Implementing the covered call strategy within an ETF framework introduces a level of complexity and diversity that individual investors might not encounter when applying the strategy to single stocks.

However, this versatility also brings with it an array of options to meet various investor preferences and goals. When discussing implementation, there are primarily two methods: active and systematic.

Active implementation revolves around the discretion of the ETF manager. In this approach, the manager has the flexibility to tactically select strike prices and expiration dates based on current market conditions and their insights.

Such adaptability can prove beneficial when navigating volatile periods or during significant market events like earnings releases. Additionally, in this setup, the manager has the liberty to write calls on specific stocks within the ETF, allowing them to target specific income generation opportunities or manage risk more precisely.

An example of an ETF that actively implements a covered call strategy is the Amplify CWP Enhanced Dividend Income ETF (DIVO). This ETF selects a portfolio of 20-30 large-cap U.S. stocks and then sells covered calls on individual positions tactically.

In contrast, systematic implementation is anchored in a predetermined methodology. Here, the ETF adheres to set guidelines that dictate which strike prices and expiration dates to use, ensuring a level of consistency and transparency.

Investors can take comfort in the predictable nature of this approach, knowing that the strategy is devoid of individual biases and follows a set structure either based on a rules-based system or a benchmark index.

An example of an ETF that systematically implements a covered call strategy is the Global X S&P 500 Covered Call ETF (XYLD). This ETF consistently writes at-the-money covered calls on the S&P 500 index with one month out until expiry on 100% of its underlying portfolio.

Beyond the mode of implementation, there's also a distinction in the types of assets that can utilize the covered call strategy. While most associate this strategy predominantly with equity ETFs, it's not exclusive to them.

Contrary to popular belief, while bonds are usually less volatile than stocks, writing calls against bond positions can prove fruitful. In certain market conditions, especially flat or volatile bond markets, employing a covered call strategy can enhance the yield of bond ETFs.

This technique offers bond investors a chance to derive an additional layer of income in situations where the bond market might otherwise offer limited opportunities, such as the bond bear market of 2022 and 2023 so far.

An example of an ETF that writes covered calls on bonds is the iShares 20+ Year Treasury Bond BuyWrite Strategy ETF (TLTW), which has strongly outperformed its regular counterpart, the iShares 20+ Year Treasury Bond ETF (TLT) year-to-date:

Benefits and risks

The integration of the covered call strategy within ETFs offers a compelling blend of opportunities and challenges that investors must weigh before making an investment decision.

One of the most pronounced benefits of this strategy is the consistent, above-average income generation it offers. By selling call options, ETFs can capture and distribute option premiums to investors. This additional income stream often sets covered call ETFs apart, especially in low-interest rate environments where traditional assets might not yield as much.

Furthermore, the strategy provides some degree of protection in protracted bear markets. While the ETF might still experience depreciation in its underlying assets during market downturns, the income generated from the option premiums can partially offset these declines.

Additionally, in sideways trading markets, where stocks might not see much appreciation, the premiums from sold call options can lead to outperformance compared to traditional equity ETFs that do not produce as much income.

However, like all investment strategies, employing covered calls isn't devoid of risks. One significant drawback is the potential to limit upside potential, especially during bull markets.

When an ETF writes a call option, and the market rallies beyond the strike price of that option, the ETF's growth is capped at the strike price. The extra income from the option premiums might not be sufficient to compensate for the missed appreciation - there's no free lunch.

Moreover, while the covered call option premiums offer some cushion, they are not a true hedge against market downturns, unlike put options or long volatility derivatives.

In the event of sharp market crashes, the collected premiums might pale in comparison to the losses on the underlying assets. As a result, investors still face meaningful downside risks that they should be aware of.

The Key Takeaway

The landscape of investment strategies is vast and varied, and within it, covered call ETFs have carved a significant niche. Their promise of consistent income generation, coupled with a degree of protection in uncertain markets, makes them a compelling option for many investors.

As we've dissected, this strategy isn't without its limitations—particularly when considering its potential to cap upside during thriving bull markets and its inability to offer full downside protection in severe downturns. Yet, the world of ETFs utilizing options strategies doesn't end with covered calls.

For those intrigued by the potential of these strategies but cautious of the inherent risks, we invite you to delve deeper with us. In our upcoming third installment in this series, we'll look at buffer ETFs.

These innovative instruments offer more than just income generation; they present avenues to strategically mitigate risk and provide a buffer against market declines. 

Please note this article is for information purposes only and does not in any way constitute investment advice. It is essential that you seek advice from a registered financial professional prior to making any investment decision.