Covered calls are an excellent form of insurance against potential trouble in the markets. When an investor with a long position in a particular asset sells a call option for that asset, generating a profit in the process, that is considered a covered call. A key to the covered call approach is that the buyer of the call option is obligated to pay a premium in order to buy it. This means that, if the asset increases in value, the seller makes even more money; if the asset declines in value, the loss is mitigated somewhat.
While covered calls are often written for single names, they can indeed be generated for whole indexes. Now, a report by ETF.com suggests that there are nearly a dozen exchange-traded funds (ETFs) focusing on this strategy. Below, we'll explore why they are a worthwhile consideration. (See also: The Basics of Covered Calls.)
Guarding Against Volatility
According to Jonathan Molchan, portoflio manager and head of product development for Horizons Nasdaq-100 Covered Call ETF (QYLD), "when volatility goes up, people typically get a little concerned. But a covered call will exhibit less volatility than the broader market." Molchan could point to his own ETF as an example of this effect. QYLD holds a monthly, at-the-money covered call on the Nasdaq-100. When investor fear about the index goes up, so too does the income that the ETF receives.
For investors in QYLD, this generates at least two benefits. First, according to Molchan, "their monthly dividend will increase," and second, "the premium received on that monthly covered-call strategy also serves as a measure of downside protection, for when the market does sell off." A covered call ETF like QYLD is unique in that it generates income from market volatility. This means that it is not sensitive to interest rate adjustments, and it doesn't experience duration risk or employ leverage. (For more, see: Covered Call Strategies for a Falling Market.)
Simplification of Covered Calls
Covered calls are relatively straightforward, but they are nonetheless more complex than many popular investing strategies. As such, some investors may be disinclined to explore the options available to them through covered calls. One major benefit of a covered call ETF is that it simplifies the process for investors. An ETF like QYLD uses Nasdaq-100 index options, which can't be exercised early. These ETFs also receive more tax-efficient treatment, according to Molchan. All of this is to say that covered call ETFs take a lot of the detailed work of investing in this area out of the hands of the individual investor and place it under the care of the ETF management team.
It's important to note that there are reasons to be cautious about getting involved in the covered call ETF space as well. As ETF.com points out, "QYLD has also missed out on a lot of upside in the Nasdaq" for this year so far, up only 8% as compared with the index's 16%. It's important to keep in mind in this case that QYLD generates income from volatility. For Molchan, it offers the best of both worlds, even if it may sacrifice some of the upside of the Nasdaq in the process. He says that "you still have the exposure to the fastest-growing companies ... you're just getting it with half the volatility of the equity index."
Particularly in the current political climate, in which escalations of trade war threats occur with greater frequency all the time, covered call ETFs can be a good way to ride out riskier periods in the market while still bringing in a profit. As ETF.com suggests, these products can allow investors to "squeeze out monthly income ... while avoiding" volatility to a significant degree. (For additional reading, check out: Managing Risk with Options Strategies: Covered Calls and Protective Puts.)