First, it’s important to understand what’s going on behind the scenes with these covered call ETFs. A covered call strategy is taking a long position in a stock and then selling call options on the same asset in the same amount as the underlying long position. This will minimize the upside payoff, but it will also expose the investor to the risk of losing money if the stock price falls.
Covered call ETFs underperformed across the board, according to the data.
Over the same time period, covered call ETFs returned an average of 8.68 percent per year, while the S&P 500 returned 14.81 percent.
The volatility of covered calls was 11.26 percent, while the S&P 500 had a little greater volatility of 13.61 percent.
By combining these two data, we can observe that the covered call ETFs’ Sharpe ratio averaged 0.73, whereas the S&P 500 averaged 1.05.
Even when we compare the average covered call, we can see that there is a significant difference.
Is it possible to lose money with a covered call ETF?
Covered call techniques, on the other hand, rarely give significant downside protection. They barely outperform by the yield premium in most cases. The S&P 500 plunged more than 30% during the COVID bear market of 2020.
What are the drawbacks of covered call ETFs?
Covered call exchange-traded funds offer exceptionally attractive yields. Is there a snag here?
When an investment appears to be too good to be true, there is nearly always a catch. Let’s look at how these income-producing assets function to see what I’m talking about.
Covered call ETFs typically have a yield of 4 to 7%, which is significantly higher than the S&P/TSX composite’s current yield of roughly 2.7 percent. The high dividends have made these products popular among income investors, who now have a choice of roughly 18 covered call ETFs to pick from in Canada.
However, if more people understood how covered call ETFs generate that additional income, they may be less enthusiastic about them. The truth is that in exchange for putting more money in their pockets, investors are losing prospective rewards and often paying expensive fees.
On a percentage of their underlying stocks, covered call ETFs sell (or “write”) call options. Because the ETF owns the stocks on which the contracts are written, they’re known as “covered” calls. A call option gives the buyer the option to buy shares at a specific price before a certain date.
When an ETF sells a call option, the option buyer pays a premium to the fund, which allows the fund to pay out greater income. We could all quit our jobs and write call options if it were that easy to generate money.
However, as the following example shows, there are risks associated with the method.
Let’s say you pay $50 for a share of ABC Corp. You want to make some additional money, so you write a $3 covered call option on your stock. Let’s pretend the option gives the buyer the right to buy your ABC share for $52 before a certain date.
You’re ecstatic because you get to keep the $3 option premium while still owning the stock. The option buyer will not call away your share if the price of ABC does not climb over the $52 “strike price” since he may acquire it on the open market for a lesser price.
What happens, though, if ABC’s market price climbs to, say, $58? Because he’s getting a fair bargain, the option holder will exercise his right to acquire the stock from you for $52. In this example, your total profit would be $5, consisting of $3 from the premium and $2 from capital gains, for a 10% return.
You think that’s fairly decent. And it is – until you compare it to the return you would have received if you hadn’t written the option in the first place. In that situation, the $8 capital gain would have been yours to keep, giving you a 16 percent return.
Although this is a simplified example, it demonstrates one of the most significant disadvantages of covered calls: In a rising market, they limit the ETF’s gains. You trade up potential future upside in exchange for cash now. This can be a bad trade-off because the stock market grows over time.
Consider the 4.5 percent yield on the BMO Covered Call Dow Jones Industrial Average Hedged to CAD ETF (ZWA-TSX). Since its inception on October 20, 2011, this ETF has generated an annualized total return of almost 14%, including dividends reinvested.
When compared to the BMO Dow Jones Industrial Average Hedged to CAD ETF (ZDJ-TSX), which does not employ covered calls and yields 1.7 percent, the BMO Dow Jones Industrial Average Hedged to CAD ETF (ZDJ-TSX) is a better bet. According to Bloomberg, its annualized total return during the same period was nearly four percentage points higher, at 17.9%. Clearly, writing covered calls while the Dow was soaring wasn’t such a good idea in recent years.
The high fees associated with covered call funds are another issue. The BMO Dow Jones Industrial Average ETF’s covered call version has a management expense ratio of 0.74 percent, while the plan-vanilla version has a MER of only 0.26 percent. Many covered call ETFs, as my colleague Rob Carrick pointed out, are also encumbered by hefty trading expenses, which act as a drag on performance. The trading expense ratio, or TER, separates out trading costs from the MER.
I’m not trying to single out BMO. Other ETF providers’ covered call funds have similarly underperformed. For example, the annualized total return – including dividends – of the First Asset Can-60 Covered Call ETF was roughly 4% for the three years ending June 30, compared to 7.4% for the S&P/TSX 60 total return index.
Covered call fund proponents say that they perform best in sideways or declining markets, which is accurate to some extent. If a stock falls in value, the method protects you from losing money, but only up to the value of the premium you paid. Furthermore, in order to maintain premium revenue, the ETF will have to write calls at lower strike prices, limiting the upside if the shares return.
Finally, because option premiums change with market volatility, the payouts of a covered call ETF may not be consistent.
Covered call ETFs may appear to be a good idea for income investors, but I prefer conventional dividend equities and ETFs.
Is it possible to lose money on a covered call?
- Writing call options against a stock that an investor owns to earn income and/or hedge risk is referred to as a covered call strategy.
- Your maximum loss and maximum gain are both limited when implementing a covered call strategy.
- If a seller of covered call options decides to exercise the option, they must provide shares to the buyer.
- A covered call strategy’s maximum loss is restricted to the asset’s purchase price less the option premium received.
- A covered call strategy’s maximum profit is restricted to the striking price of the short call option, minus the underlying stock’s purchase price, plus the premium received.
Is it possible to sell covered calls on ETFs?
On the surface, the concept behind making calls on your existing holdings appears to be highly compelling and simple to comprehend. You have your possessions, and you sell the right to buy them at a price that is higher than the current market price to another investor in exchange for cash. The concept is that if you write call options far enough out of the money, they will expire worthless the vast majority of the time, you will risk relatively little while gaining a steady stream of revenue.
The technique is appealing because the benefits are clear to see and grasp, and they begin to accrue right away. The investor continues to benefit from the appreciation of their stock holdings up to the strike price, just as they would otherwise.
Why are covered calls bad?
Taxes and transaction expenses are two further factors to consider. Because some or all of the revenue (depending on whether one is selling options on indexes or individual stocks) is regarded as short-term capital gains, covered call tactics result in tax inefficiencies. The foregone capital gains that are lost when options are exercised, on the other hand, are taxed at capital gains rates. Covered-call techniques have substantial transaction costs when compared to passive buy-and-hold strategies. Because of the rapid turnover, there are charges associated with commissions and bid-offer spreads, as well as possibly market impact fees.
Are Covered Calls a Good Investment?
The covered call strategy is best used on stocks with little expected upside or downside. Essentially, you want your stock to remain stable as you receive premiums and lower your monthly average cost. Remember to factor in the cost of trading in your calculations and scenarios.
Covered call writing, like any other strategy, has benefits and drawbacks. Covered calls, when used with the correct stock, can be a terrific method to lower your average cost or produce revenue.
What is the Nasdaq 100 ETF?
The Global X Nasdaq 100 Covered Call ETF (QYLD) employs a “covered call” or “buy-write” strategy, in which the Fund purchases Nasdaq 100 Index securities while “writing” or “selling” call options on the same index.
How do you profit from covered calls?
The buyer of a call option pays a premium to the seller in exchange for the right to buy shares or contracts at a preset future price. The premium is a cash fee paid on the day the option is sold, and it belongs to the seller whether or not the option is exercised. A covered call is most beneficial if the stock rises to the strike price, allowing the call writer to profit from the long stock position while the sold call expires worthless, allowing the call writer to collect the entire premium on the sale.
Are calls to Robinhood covered?
Selling a covered call entails entering into a contract that obligates you to sell shares of a stock you already own at a specific price (the “strike price”) until a specific date (the “expiration date”). In exchange, you will be given a lump sum payment (the advance payment) “premium”) for the contract’s sale. A typical short call option comprises the responsibility to sell 100 shares of the underlying stock, and the call is exercised when the underlying stock rises in value “Because you already own the shares you could have to sell, you’re “covered.”
Because you have this duty and own the stock, it is in your best interests for the stock price to remain relatively stable or mildly increase, and it is in your best interests for the stock price to decline dramatically. Your maximum potential profit is limited, but so are your maximum potential losses.
To express how your short covered call option is behaving in relation to the stock price, here’s some jargon:
What happens if the strike price of a covered call is reached before it expires?
You want the market price to be higher until the expiration date if you’re holding a long call position. Your contract is virtually worthless on the expiration date once the strike price is achieved (since you can purchase the shares on the open market for that price).
The long call will typically have value prior to expiration as the stock price climbs towards the strike price. This is especially true when the call option still has time value and the share price has risen faster than time decay has eroded its value.
You can choose not to exercise your option and instead sell it to grab whatever premium remains when the market falls. But, if the stock market falls, how can you earn money buying options? The good news is that calls aren’t the only long-term choices available in the market.