What Is a Covered Call ETF?

Investors who are looking for a source of income and a hedge against volatility may want to consider adding a covered call ETF to their portfolio. A covered call ETF is a type of exchange-traded fund that uses a strategy known as covered call writing to generate income for its investors.  

In this article, we will explore what a covered call ETF is, how it works, its benefits and risks, and some examples of popular covered call ETFs. 

What Is a Covered Call ETF? 

A covered call ETF is an exchange-traded fund that uses a strategy called covered call writing to generate income for its investors. Covered call writing is a strategy in which an investor sells call options on a security they own in exchange for a premium. The premium received from selling the call option provides additional income for the investor. 

Covered call ETFs typically invest in a portfolio of stocks and then use the covered call writing strategy on a portion of their portfolio. By using this strategy, the ETF can generate additional income for investors while still providing exposure to the underlying stocks in the portfolio. 

The largest covered call ETFs, as measured by assets under management, are the Global X NASDAQ 100 Covered Call ETF (QYLD) and the Global X S&P 500 Covered Call ETF (XYLD). The most popular ETF that includes covered call writing among its multiple strategies is the JPMorgan Equity Premium Income ETF (JEPI). 

How Do Covered Call ETFs Work? 

Covered call ETFs work by investing in a portfolio of stocks and then selling call options on a portion of those stocks. The call option gives the buyer the right, but not the obligation, to buy the underlying stock at a specific price (known as the strike price) on or before a certain date (known as the expiration date). In exchange for selling the call option, the ETF receives a premium. 

If the price of the underlying stock does not reach the strike price before the expiration date, the call option will expire worthless, and the ETF keeps the premium as income. If the price of the underlying stock does reach the strike price, the ETF will have to sell the stock to the option buyer at the strike price but will still keep the premium as income. 

The strategy of covered call writing can help reduce the volatility of the ETF's portfolio by providing a source of income and a potential hedge against market downturns. However, it's important to note that the strategy also limits the potential upside of the underlying stocks. If the price of the underlying stock increases significantly, the ETF may have to sell the stock at the strike price, missing out on any additional gains. 

Benefits and Risks of Covered Call ETFs 

Covered call ETFs offer several benefits, such as reduced volatility and income generation. However, these ETFs also present some risks, such as market risk and option risk, that investors should know about before buying shares of these funds. 

Here are some of the main benefits and risks of covered call ETFs: 

Benefits of Covered Call ETFs 

• Reduced volatility: By selling call options, the ETF can provide a potential hedge against market downturns and potentially outperform the market. This can help reduce overall portfolio volatility and smooth out returns over time.  
• Income generation: Covered call ETFs are designed to generate income for investors by selling call options on the underlying stocks in the portfolio. This can provide a steady stream of income, making them a popular choice for investors looking to supplement their retirement income or generate cash flow from their investments. 
• Tax efficiency: Because covered call ETFs generate income through the sale of call options rather than through dividend payments, they may be more tax efficient than other types of income-generating investments. 

Risks of Covered Call ETFs 

• Market risk: Like all stock investments, covered call ETFs are subject to market risk. If the overall market declines, the ETF may decline in value, even if it generates income through the sale of call options. 
• Option risk: Selling call options also comes with its own set of risks. If the price of the underlying stock increases significantly, the ETF may have to sell the stock at the strike price, which could result in a loss. 
• Counterparty risk: When an investor sells a call option, they are entering into a contract with the buyer of that option. If the buyer is unable to fulfill their end of the contract (i.e., pay for the underlying stock), the investor may be left with a loss. 

How Are Covered Call ETFs Taxed? 

Covered call ETFs are uniquely taxed due to the way they generate income. As mentioned earlier, covered call ETFs generate income by selling call options on the underlying stocks in the portfolio. This income is typically referred to as "option premiums" and is subject to special tax treatment. 

Option premiums received by the covered call ETF are considered short-term capital gains and are taxed as ordinary income. This means that the income generated by the ETF is taxed at the investor's marginal tax rate. Short-term capital gains are subject to higher tax rates than long-term capital gains, which are typically taxed at a lower rate. 

Investors who hold covered call ETFs in a taxable account must report the income generated by the ETF on their tax return each year. The income is reported on Schedule D of Form 1040 and is subject to the same reporting requirements as other capital gains and losses. 

It's important to note that covered call ETFs may also generate long-term capital gains or losses when the underlying stocks are sold. These gains or losses are also reported on Schedule D of Form 1040 and are subject to the same reporting requirements as other capital gains and losses. 

Bottom Line 

Covered call ETFs can be a good option for investors looking for a hedge against volatility and income generation. However, it's important to consider the risks associated with the strategy, including market risk, option risk and counterparty risk. As with any investment, investors should carefully evaluate their investment objectives, risk tolerance, and investment time horizon before investing in covered call ETFs.