What Are Covered Call ETFs? High Dividends for Low Growth (Feb 2024)

Take a quick stroll through social media and you’ve probably seen a number of accounts mentioning covered call ETFs. These are especially beloved by dividend and income-focused investors. As we will see, these funds have a role to play for some investors, but they certainly are not for everyone. So what are covered call ETFs? These are actively managed ETFs that hold a portfolio of stocks or assets, against which the fund managers write covered call options contracts.

What is the purpose of carrying out this options strategy inside of an ETF? As you might already know, writing covered calls provides a generous income stream from collecting premiums. The funds collect these premiums and distribute them to shareholders as dividends. Therefore, the purpose of covered call ETFs is to provide you with as much income as possible through quarterly or monthly dividends. In this article, we will dive deeper into covered call ETFs so you can decide if they belong in your portfolio.

What is a Covered Call?

Let’s have a quick review before we go into what covered call ETFs actually provide you. What is a covered call? It is an options strategy that leverages shares you already own to write protected call options. This generates income in the form of premiums allowing you to earn money on the stocks you own and like.

Now, even though you own the stocks, writing covered calls is a slightly bearish trade. How can it be bearish? You are placing a bet that the stock’s price will stay below the strike price of the call by the expiration date. Traditionally, covered calls are written at the money or slightly out-of-the-money. This means the strike price is at the current price of the stock, or slightly above it.

When you write a call option you get two possible outcomes:

1. The price of the stock stays below the strike price and you collect the premium. You also keep the shares that you wrote the call against.
   
2. The price of the stock rises above the strike price and you collect the premium. In this scenario, your shares are assigned away to the buyer. This means you sell your shares at the strike price of the call option.

So why do we refer to this as a covered call? The best way to put it is that you are “covered” in case your shares get assigned. Rather than having to put up capital to pay for 100 shares of the stock, you are merely selling your own shares. If you didn’t own the shares, it would be called a naked call option. In the event that your shares get assigned and you don’t own them, you will need the funds in your account. This can be a very expensive lesson for new traders.

Example of a Covered Call

Let’s look at an example of a covered call, so you can have a visual of the trade process:

To keep things simple, we will be using round numbers for all of the prices.

Say you own 100 shares of Tesla (NASDAQ: TSLA). Tesla is a great stock to sell options on because the volatility in the price leads to higher premiums. So let’s sell a covered call against TSLA.

For this example, let’s say TSLA is trading at $100 per share and you bought them at $100 as well. In this trade, we will be looking at the slightly out-of-the-money contract at the $102 strike price.

Let’s not worry about expiration dates or rolling strategies right now either!

If you sell the $102.00 covered call for TSLA, you can earn $100 in premium. Great!

So let’s look at the first scenario: the price stays below the strike price of $102. Well, you keep the $100 in premium and your 100 shares of TSLA. Also great!

In the second scenario, TSLA’s stock price rises to $104 at the expiration date. Now what?

Well, first we know that you keep the $100 premium from the trade. We also know that your 100 shares of TSLA will get assigned. This means you are selling them at the strike price of $102.

When you sold them at $102, you made $200 in profit. You also earned the $100 in premium from selling the call option. So, in the end, you are up by $300.

But, if you had just held onto your TSLA shares, you would be up $400. This is the reality of trading options. Sometimes you will leave money on the table. Would you have sold your TSLA shares at $104? Likely not.

What is a Covered Call ETF?

Now that we know what a covered call is, a covered call ETF uses this options strategy to earn additional income. What do they do with those premiums? They pay it out to shareholders as dividends. This is why covered call ETFs have some of the highest dividend yields on the market.

How high are these yields? Most will pay in the double digits. Covered call ETFs also tend to pay out dividends on a monthly basis. This usually has to do with the expiry of monthly options contracts.

The trade-off for the high yield is that covered call ETFs do not see much in the way of capital appreciation. This means the price of the ETF does not rise or fall by much over time. You sacrifice capital growth for a present-day income stream. This provides some stability during a volatile market, but you could lose out on gains when the market turns bullish.

One thing to note: covered call ETFs tend to have a high MER or expense ratio. This means you pay more fees, the more you have invested. Why are the fees so high? Covered call ETFs are actively managed and require more attention trades from the ETF provider. This is in contrast to an index fund like the Vanguard S&P 500 ETF (TSE: VFV) which has low fees for just tracking the index.

What are the Best Covered Call ETFs in 2024?

BMO Covered Call Canadian Banks ETF (TSE: ZWB)

BMO Global Asset Management’s ZWB is a popular income source for Canadian investors. This provides exposure to the big six banks in Canada as well as BMO’s popular Equal Weight Banks Index ETF (TSE: ZEB). Since this ETF was introduced in January 2011, it has returned 163.79% without factoring in dividend reinvestment. As of February 2024, ZWB offers a dividend yield of 7.51% that it pays out monthly to shareholders. ZWB has a fairly high expense ratio of 0.71%.

Global X Nasdaq 100 Covered Call ETF (QYLD)

If you have spent any time on Financial Twitter, you will certainly have heard of QYLD. This ETF trades on the NYSEARCA exchange in US dollars. It sells covered calls on NASDAQ 100 stocks like Apple, Tesla, Microsoft, and Amazon. The ETF was introduced in 2013 and has provided nearly 120% appreciation to shareholders. As of February 2024, QYLD provides an 11.89% yield which it pays every month. The expense ratio is 0.60%. Global X has similar ETFs that trade-covered calls on the S&P 500 and the Russell 2000. These trade under the symbols XYLD and RYLD respectively.

Here are the top 10 holdings in QYLD:

JPMorgan Equity Premium Income ETF (JEPI)

JEPI is a relative newcomer to the covered call ETF sector. It was established in 2020 and has quickly established a strong following. This ETF focuses on blue-chip stocks from the S&P 500 and the Dow Jones Industrial Average. The stocks might not be attractive to growth seekers, but it provides a defensive portfolio when the market is turbulent. JEPI currently pays out a dividend yield of 7.04% that it pays out monthly to shareholders. It also has a lower MER of just 0.35% which is nearly half of QYLD and ZWB. There is also an ETF that trades covered calls against NASDAQ stocks which trades under the symbol JEPQ.

YieldMax TSLA Option Income Strategy ETF (TSLY)

The newest covered call ETF of them all is TSLY which is focused entirely on Tesla’ stock. We mentioned before that Tesla has incredible options premiums because of its day-to-day volatility. While it has only been traded for a few months, it has provided extremely generous yields. While the 30-day SEC yield is posted at 3.90%, the actual yield is a staggering 74.78i%! Collect these on a monhtly basis for some serious capital flow. The expense ratio is high at 0.99%, so use your own discretion because over time the yield will likely fall lower.

What are the Pros and Cons of Covered Call ETFs

Pros

• Earn a high-income stream through monthly dividend payments
• Price stability can defend you from volatility in the market
• Covered call ETFs take the trading out of your hands
• You can invest in covered call ETFs in any account

Cons

• There is not a lot of capital growth for covered call ETFs
• The expense ratio is high as the funds are actively managed
• Depending on the stock prices and options, the dividend amount can be volatile
• The taxes can be complicated, depending on what the dividends are considered

Are Covered Call ETFs A Good Investment in 2024?

The answer to this question is going to vary from investor to investor. As you can tell, covered call ETFs really only serve one major purpose: income flow. This is why it is great for retired investors or those seeking to accumulate capital before retirement.

For growth investors, covered call ETFs might not serve much of a purpose, yet. With years and even decades ahead of you, focusing on high-growth investments is probably a better strategy.

Before we sign off, there are a couple things you should be aware of when investing in covered call ETFs. The first is that covered call ETFs tend to charge higher expense ratios. This means a larger portion of your future gains will be lost to paying these fees.

The other thing is that covered call ETFs are complicated for tax reporting. For example, QYLD dividends are taxed as short-term capital gains that are made through trading options. But JEPI has a more tax-friendly structure. It holds equity-linked notes that earn interest. This allows JEPI dividends to be taxed as normal. Always be aware of tax implications of the ETFs and the accounts you hold them, before investing.

Ultimately, it is your decision to invest in covered call ETFs. Do your due diligence and research and decide if they work in your long-term, or short-term, investment strategy.

Stay Savvy!