How Covered Call ETFs Can Help Generate Income in Any Market
The financial markets have been extremely volatile over the past year as geopolitical tensions, high inflation, and rising interest rates have rocked asset prices. With so much uncertainty continuing to swirl, many investors are understandably concerned about protecting the purchasing power of their portfolios during these turbulent times. While getting too defensive could hinder growth potential, failing to generate income leaves your savings susceptible to erosion from inflation. Thankfully, a covered call strategy employed through exchange-traded funds (ETFs) offers a balanced approach that focuses on generating steady income while mitigating downside risk.
One of the leading covered call ETFs is the Global X Nasdaq 100 Covered Call ETF (QYLD). This fund employs a “buy-write” strategy, whereby it owns all the securities in the Nasdaq 100 Index and simultaneously writes or sells call options on that same index. A covered call strategy seeks to augment the income generated from stock dividends and option premiums. With over nine years of steady monthly distributions totaling more than $9.5 billion paid out, QYLD provides an insightful case study on how this options strategy can deliver income stability in changing market conditions.
Generating Income from Premiums
When you write or sell a call option, the buyer obtains the right, but not the obligation, to purchase the underlying asset at a predetermined strike price by a specified expiration date. In return, you receive an upfront payment known as the option premium from the buyer. QYLD collects premiums by writing near-term calls that are generally 5–10% out-of-the-money on the Nasdaq 100. This level helps maximize option premium collection while limiting the potential for the calls to be exercised.
Over its history, QYLD has averaged a covered call yield of around 11–13% annually from premiums. During 2022 when rates and volatility have risen sharply, its distribution yield has remained resilient around 11.5% despite a bear market in stocks. These premiums provide the primary fuel for QYLD’s steady monthly payouts, which have averaged a 12-month trailing yield of about 12.5% over the past year, handily outpacing inflation. By generating income through option selling instead of dividends alone, covered call funds like QYLD can continue rewarding shareholders even when underlying stocks are cut or suspend their dividends.
Limiting Downside with Upside Participation
In addition to boosting income, the covered call strategy employed by QYLD aims to smooth returns and provide some downside protection relative to its benchmark index. Over the past three years, QYLD has exhibited about 30% less volatility than the Nasdaq 100 according to its beta. On a cumulative basis, QYLD has given back 5.1% over the past year compared to the index’s 5% loss. So while still participating to the upside, it has shown resilience on the way down.
This is because option writing tends to limit upside potential in favor of downside buffering. When the underlying stocks decline, the calls written provide some downside insulation since they lose value and premium collection is able to continue. Likewise, if stocks surge past the strike prices, upside participation may be capped at the call prices. However, the income generation helps offset any participation constraints, allowing investors to potentially benefit from steady income even when markets fall. This risk-managed approach makes covered call funds like QYLD well-suited for uncertain times.
Targeted Upside Participation
While calls provide some downside protection, they also allow QYLD to participate in a portion of upswings. Significant option premium is generated when markets are volatile, whether rising or falling. And since QYLD writes near-term calls that are just above current prices, its upside is not severely restricted until the Nasdaq 100 makes substantial gains above recent highs.
For example in 2021, the Nasdaq 100 surged around 26% yet QYLD still managed to return about 16% including distributions. Overall since inception in late 2013, QYLD has kept pace with over 85% of the Nasdaq 100's cumulative 105% gain despite its income focus. By strategically writing calls on an ongoing basis and rolling options as they expire, QYLD aims to sweeten income without overly hampering upside participation potential in bull markets. The flexibility of this approach makes it well-suited for dynamic markets.
Cost-Effective Exposure
Another key advantage of QYLD is its low cost structure, which enhances its income-generating capabilities. With a tiny expense ratio of just 0.60%, nearly all the option premiums it collects go towards shareholder distributions rather than fees. Compare this to actively managed mutual funds charging 1–2%, and the cost savings really add up over the long-term. ETFs are also generally more tax-efficient than mutual funds due to lower portfolio turnover.
By providing Nasdaq 100 exposure through a covered call strategy at a lower cost, with built-in downside buffers and steady income, QYLD presents a compelling portfolio solution for various market conditions. For investors seeking to enhance overall returns, generate inflation-beating income, or simply take some reinsuring measures against volatility, covered call ETFs deserve consideration. A well-constructed options overlay can meaningfully improve the risk-return dynamics of a traditional stock holding.
The Income Potential of Covered Calls is Compelling
Beyond any single fund, the covered call strategy itself holds enduring appeal. By proactively selling call options, one can potentially generate significant income that is not reliant on stock dividends or interest rates. In a rising rate environment, this diversifies income sources and provides a hedge. Likewise in a falling market, it may help soften volatility and support recurring cash flows. The act of writing options requires analysis but allows for potentially benefitting from either falling, rising, or range-bound markets.
Perhaps most importantly, covered call ETFs free up investors’ time by outsourcing options management to professionals. By owning a single ETF, one gains instant diversified exposure to an options overlay strategy. Distributions are also easily scheduled for budgeting needs. While not removing risk entirely, covered calls introduce elements of downside protection and income enhancement to stock holdings —attributes that are highly valued amid persistent uncertainty. For long-term investors seeking to deploy a balanced, low-maintenance approach, covered call funds warrant serious consideration as a complement to core portfolio positions. Through all market cycles, their income focus has proven resilient.
The Nasdaq 100 continues powering innovation globally as technology transformation reshapes our world. By selectively writing calls on this influential index through QYLD’s options strategy, investors gain focused access to tomorrow’s leaders while also collecting premium income. Especially in volatile times, a covered call approach provides a prudent, disciplined means of participating in the growth opportunities ahead while furthering other financial goals like protecting principal or supplementing income needs. Over the long-run, strategically marrying stocks and options has credibly delivered on multiple fronts for patient investors.
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Portions of this article were inspired by and reference “Nasdaq 100 Covered Call ETF (QYLD)”, originally published at https://www.globalxetfs.com/funds/qyld/ on November 21, 2023.
