Why Use A Covered Call ETF?

August 07, 2018

Jonathan MolchanWorried that equity markets are getting overheated? Covered calls—and covered call ETFs—can help.

Covered calls are essentially insurance products, where an investor long in a given asset "writes" (or sells) a call option on that asset as a means of generating income (read: "Exploring Covered Call Strategies").

For example, say you purchase a stock for $100, but you think it has the potential to go up to $110 within a year. You'd also be willing to sacrifice some upside, however, to take profits in the short term. You could write a $105 call option, meaning you'd be obligated to sell the stock to the holder of that option for $105, if and when the underlying price hits that level.

So how do you generate income on the covered call? The buyer of that call option must pay some premium to buy it—let's say $3/share. You get to keep that premium, no matter what. So if the stock hits $105, you make $108 on the sale. But if the stock falls to $90, your loss on the original position is only $7, with the $3 premium offsetting the $10 loss. 

Covered calls can be written for single stocks or whole indexes, and are a convenient way to reduce volatility while capturing some exposure to equity market gains.

Ten ETFs now package the covered-call strategy, including the $309 million Horizons Nasdaq-100 Covered Call ETF (QYLD), which holds monthly covered calls on the Nasdaq-100 Index. QYLD is a unique way to play equities, and tech stocks in particular, allowing investors to squeeze out monthly income from the high-flying sector while avoiding its volatility.

Recently we spoke with Jonathan Molchan, portfolio manager and head of product development for Horizons ETFs (USA), to discuss how investors can use covered-call ETFs in their portfolios.

ETF.com: The trade war news cycle moves so quickly these days. Every day, it seems the administration is either levying new tariffs, or threatening to do so, or calling off ones they'd already levied, and so on. But the markets remain fairly stable, no matter what Trump says or does. Do investors care about the threat of a trade war anymore?

Jonathan Molchan: I agree, price action in the market has been rather resilient, given the headlines. I tend to think that [President Trump's] trade war threats are more of a negotiating tactic instead of an absolute end outcome.

In regard to how they've impacted the market, this has been a great first half of the year. In historical standards, if you're up eight to 10 [percentage] points on the S&P 500 or the Nasdaq, that's a tremendous year. We're already there, if not exceeding it, depending on which index you look at.

ETF.com: Is there a real-world impact that tariffs can and will have on American businesses? And are investors inaccurately assessing the real damage they could cause to our markets, because they're just brushing it off as, "There goes Trump; off on one of his tirades again"?

Molchan: The headlines and threats are very real. The impact—not just to America but to other countries, companies and individuals—is very real. But I think the resiliency in the markets is probably due to the fact that if you're going to have money in the market, really the only place to be is in the equity markets. If you were to have sold during any of the earlier, smaller market corrections, you'd be kicking yourself right now.

Yes, the equity market is ensnared in headlines around trade wars, tariffs and questions about whether the market is too top-heavy. But what's your alternative? In the fixed-income complex, people every 15 minutes are talking about the inversion of the yield curve. Your only real alternative, if you didn't want that exposure, would be to go to cash—but there's the third conversation, which is, you'd be crazy to go to cash.

ETF.com: How does a covered-call options strategy offer some protection to investors who want to stay invested in the equity market, but maybe not ride in the car going 200 miles an hour around a hairpin turn?

Molchan: When volatility goes up, people typically get a little concerned. But a covered call will exhibit less volatility than the broader market.

Take “QYLD” [the Horizons Nasdaq-100 Covered Call ETF (QYLD)], which holds a monthly, at-the-money covered call on the Nasdaq-100. It offers income sourced from volatility: As fear starts to go up, so does the income received.

That benefits investors in two ways. Their monthly dividend will increase, and the premium received on that monthly covered-call strategy also serves as a measure of downside protection, for when the market does sell off. And if you look at the market volatility that occurred earlier this year, QYLD was down less than the market. Our trading range is about half that of the Nasdaq-100.

What's really differentiating about QYLD is that, unlike traditional income watering holes, it sources income from market volatility. It doesn't have interest rate sensitivity. There's no duration risk. You don't have the commodity exposure of MLPs, and it doesn't employ leverage. It's equity exposure and monthly income uncorrelated to traditional income deals.

ETF.com: At the same time, QYLD has also missed out on a lot of upside in the Nasdaq. The Nasdaq-100 is up 16% year-to-date, but QYLD is only up 8%. Why cap the upside from some of the fastest-growing stocks on the market?

Molchan: My response is: income, income, income. If you're looking for an alternative source to generate income, QYLD is your product.

And why I think that is a great alternative to just owning, say, a basket of FAANG, or the broader [Nasdaq] index. You still have the exposure to the fastest-growing companies—the names behind the growth in equities markets that we've seen over in the last handful-to-10 years. You're just getting it with half the volatility of the equity index.

ETF.com: Covered calls aren't particularly complicated in concept, but they're certainly more complicated that vanilla exposure to an index. Are options-strategy ETFs like QYLD just too complicated for regular investors to implement?

Molchan: We've simplified a lot of the process. QYLD uses NDX index options, which are much different than single-stock options. They can't be exercised early, and they settle for cash. One index option fully replicates the holdings of the Nasdaq-100, and the Cboe publishes the strike in a transparent fashion. It's just one strike, not 100.

The other great thing about using index options is that they are 1256 contracts. [Ed. Note: "1256 contract" is the IRS term for a regulated futures or options contract.] They receive more tax-efficient treatment: They're taxed 60% long term, 40% short term, whereas a single stock option would be 100% short term.

Contact Lara Crigger at [email protected]

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