Unlocking Income: A Comprehensive Guide to Investing in Covered Call ETFs
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Locking the money for the rest of us. This is a personal financial on money, how IT works, how to invest IT and how to live without worrying about IT. I'm your host, David stein.

Today is episode four seven. One is titled unlock king income, a comprehensive guide to covered call etf two weeks ago, and I pad four sixty seven, I mention that the largest actively managed etf in the U. S.

Is the J P. Morgan equity premium income etf. IT has over thirty billion dollars in assets, and IT took in close to thirteen billion dollars just in twenty twenty three alone.

This E, T, F, invest in a strategy known as covered calls, is also known as a by right strategy. There is a similar etf, the global x masked at one hundred cover called etf. Tikka is Q Y L D, has over eight billion dollars in assets under management, a similar strategy to J E P I.

The J P Morgan equity premium income etf recently had a member of money for the rest of plus our premium membership community post in the form about strategies like this, where in this remembering view, the returns are are potentially twelve percent because that's the yield ld on the global x and act one hundred cover call. Etf Q I L D is a difference between the yield and the actual return. If we look at the ten year analyzed return for Q Y L D spent seven point two percent analyzed, and over the past three years that returned five percent despite the very high yield, IT lost nineteen percent in twenty twenty.

And and this member was looking at these high yielding etf and was asking, well, why not invest in them if they could earn to fifteen percent per year with little downside? Seems like a great investment. Now if we could find investments with little downside that could earn twelve to fifteen percent annual, zed, that would be a beautiful environment.

But unfortunately, IT doesn't exist perhaps for a short period of time, but ten years analyzed double digit returns with little downside risk don't exist. But covered call strategies can be an attractive addition to our portfolios. So in this episode, we want to look at what is a covered call strategy, how does that work? What are the risks? Under what circumstances do they do well and when will they do poorly?

A diversified covered call investment strategy like we're going to talk about today are also known as bytes strategies. IT consists of two steps. One, we buy an investment that could be an individual stocks, a basket of stocks that comprising index, such as the stocks that make up the S M, P five hundred.

The investment could be N, T, F, that tracks an index such as the S, M, P. Five hundred, or the investment could be a band etf. And we will look at some covered call strategy e tf that where the underlying investment is bonds that step one buying investment.

The step two is sell a call option on the underlying investment. Selling a call option is also known as writing a call option. And that's why the strategy is sometimes called by right, we buy by the investment and then we write a call option.

When we sell a call option, we receive premium income. Just like an insurance company that underwrite an insurance policy, they receive a premium in return for paying out a claim. If something happens, if someone's cars, stone or a housework ns down a call option is similar, the seller act like an insurance company in terms of they will receive premium income and then they pay a claim.

If something specific happens, an insurance company makes what's known as an underwriting profit if the claims that they pay are less than the premium income received and what they might earn on their investment portfolio. A covered cost strategy is similar. The cellars of a call option earn a profit if they claim IT pays on the option contract are less than the premium received and what the seller earns on its underlying investments.

Now with options, the claims paid depends on the return of the underlying investment. And with a call option, if the Price of the underlying investment, let's say it's the S M P five hundred index goes up and IT exceeds, which known as the exercise Price or the strike Price that the option is written for, then the buyer that option receives a payment. So for example, there is an investment where the strike Price for the call option is one hundred dollars and the investment goes up to one hundred and five dollars.

Then the bar that option receives five dollars, and the seller or writer that option would pay the buyer five dollars the buyers profit, or that call option would be the five dollars that they receive, less the premium that they paid the profit for the seller. Or the call option would be whatever premium they received for writing the option, less any payments they have to make on that option. When we think about a covered call strategy, there's two components.

There's the investment component, the underlying investment, and then there's the call option that generating the premium. The buyer, the call option is purchasing a right to receive a cash payment. If the underlying investment that option is linked to exceed a specified level, specified level, then is the strike Price or the exercise Price.

The benefit of buying a call option is that the option buyer has no exposure to the investment falling in Price. They just have optionality for the investment going up in Price above the strike Price. A key component of covered costa teaches is that the option that is written is sold at the level of the underlying investment if that been etf or an individual stocks, because a call could be written at a strike Price that might be ten percent above the current level of the index.

And so the claim would only have to be paid if the other investment went up ten percent. But the point of a covered cost strategy is to generate as much income as possible. And so the strike Price to sell the option equals the current level of the index.

And generally with cover cost strategies, the time frame for the option is thirty days, so IT expires in thirty days. The covered call rather than is giving away all the Price appreciation for the underlying investment because of the strike Price being equal to the index level. So this is an an intriguing strategy.

If we think about the return, a cover cost strategy, IT equals the dividends or the interest on the underlying investment plus the premium receive for writing the option minus any claims they have to be paid to the option buyer, which effectively because the strike Price equals the the level of the index is all the Price appreciated option bia gets all that the option seller in a covered cost strategy doesn't get the Price appreciation. They just get income from interest in dividends, the option premium, but they also have exposure to all the downside. So if the investment goes down in Price because they own the underlying investment, then they lose money.

So there's kept upside and unlimited downside. So this is not a risk free investment. There is the potential to lose money.

Although over the long term, cover cost strategies have earned six to seven percent analyzed, let's go through a numerical example using S M P five hundred options. When I did this example, the S M P five hundred index, this is a measure of us. Large company stocks was selling at fifty one fifty.

I could sell a call option at the fifty one fifty level, and IT cost eighty five dollars. Now, the way that options work is there is a multiple er of one hundred. If I just write one call option on the S N P at a level of fifty one fifty that expire in thirty days, I would receive eighty five hundred dollars in premium income.

And then every point that the S. M P five hundred win up, because i'm paying all the Price appreciation to the option buyer, every point would cost me one hundred dollars. So if the S.

M P. Five hundred climbed eighty five, point went from fifty one fifty up to fifty two thirty five. That's about a one point six percent gain. That would cost me eighty five hundred dollars, which means all the premium income I received, I would have just given back back to the buyer of the option.

Now one of the keys to a cover cost strategy is owning the underline investment so that all the Price gains in the investment are unprotected. So as the S M P. Five hundred would go up, because I own the S M P.

Five hundred and i've sold options on the S P, i'm getting Price gains. I'm underlying investment, then paying them out to to the buyer of the option. The amount of the underlying investment that I need your own is call the national amount and that refers to the the value of the underlying assets that tied to the option.

And in this case, the the notional amount is one hundred times the level of the S N. P. So one hundred times fifty one fifty is five hundred and fifteen thousand dollars.

That's how much money I would need to put in the S. M. P. Five hundred in order to be protected in selling one call option that eighty five hundred dollar premium.

If I I have less than that, then i'm going to have to scramble if I want to be completely immunize from gained in the S. P. So every or gain in the S.

P. Five hundred covers my exposure to the option I wrote. Then I need to have five hundred fifteen thousand dollars in the s and p. That's why many individuals that use cover call options, they want to do IT on their own. They'll right cover calls on exchange traded funds.

So the Price of the I shares core S M P five hundred etf I V V is five hundred and fifteen dollars, which means the notional value that I would need to hold is one hundred times that are fifty one thousand five hundred dollars. And the call Price that I would receive for selling one call option on I V V is eight dollars and fifty cents. We multiple that by one hundred as I would receive a premium of eight hundred fifty dollars for one call option with a notional value, the value of the underlying asset of fifty one thousand five hundred dollars.

So let's review this. There are two scenario for returns when employing a covered cost strategy. Recall that we have the money that we've put into the underlying investment and then we have the call option that we sell.

The first scenario is the investment falls in Price by more than the premium income we receive for writing the call option and by more than the dividends that we receive on the stock portfolio. If it's a covered cause strategy employing stocks or stocky T S, or the interest would receive on the bond portfolio were used covered cost strategy employing a bonita. If the investment falls in Price by more than the income we received, that's a loss, a negative return in an extended bear market where the market goes down every month, we're going to lose money.

This is the lowest return scenario, but we call that we're writing thirty day options. And so in order for an extended loss in area the market, we have to go down every single month because as we write new options every month, we get more premium income and the strike Price level is adjust IT based on whatever we write the option to that the first scenario. The second return scenario is the underlying investment goes up in Price.

In that case, we receive the dividend or interest income and we receive the premium income. But all of the gains in the underlying investment that were receiving because we own the underline are being paid out to the option holder because we sold a call option on the underlying investment. So ultimately be a cover cost strategy.

Is income generating because of the premium income and the income generated by the underlying investment. There is no upside beyond that because we're paying out gains to the option holder, but we're exposed to all the Price downside on that underlying investment that we own. Let's consider, we write an option on Q Q, Q, the max one hundred etf.

This would be a strategy similar to what the global x ash at one hundred cover call etf does. Q Y L D IT owns the next act one hundred. And then write call options on that index.

We look at the pricing of Q Q Q options. One option at the current level of Q Q Q will generate a thousand dollars with a notional amount of one hundred times the level. Q Q Q, which is four hundred and thirty eight dollar s so the notional amount is forty three thousand eight hundred.

We get a premium of a thousand dollars if we write a call option at the current level, that's two point two percent return turn per month, twenty six point four percent per year. If Q Q, Q doesn't go down a Price, twenty six percent per year, just an option premium plus a small dividend yield that Q Q Q might have, that's not bad, except that's not the way IT works because we know that the market will go down some months. The worst case loss for a cupboard cost strategy, in this case Q Y L D, that is based on Q Q Q, was a twenty five percent loss that was pretty significant.

We look at the longer term return for Q Y L D. Its return seven percent analyzed for the five years and the ten year, around seven point two percent. Before we continue, limit, pause and share some words from this week.

Sponsors with covered cost strategies, amount of premium income received will vary over time. What determines the premium is how much time until expiration, and with covered cost strategies is typically thirty days. The current Price of the index or the underlying investment relative to the strike Price, when the option contract is is either bought or sold, the closer the strike Prices to the current Price, the more premium income.

Just why with a covered cost strategy, the idea is to sell a option at the current level of the underlying investment in order to get the most premium income we can based on the strike Price in the exercise Price recovered cause strategy typically always written at the current level of the underlying investment, thirty days to maturity doesn't have to be, but that's just typically how it's done. And then another driver then is the expected volatility of the underlying investment. Something like Q Q Q is more violent than the S P five hundred because Q Q Q is is greater percentage technology stocks.

And the only one hundred stocks versus the S P five hundred has five hundred stocks and it's more diversified. So the matildy of the S M P is lower than the NASA one hundred, which means the option premium income is higher for options on Q, Q, Q compared to options on the p five hundred. That measure of volatility are expected volatility, implied volatility for the S N P is called vx V I X.

You might heard of that, but other investments would have other names for this is called the employed or expecting volatility. And the higher that expecting volatility, the greater the option premium. Then in marketer in a cell off or down or there is more voluable than a covered cost strategy, you can earn more premium income because options are more expensive.

And so you're getting more money if you sell them now. But the man can impact the option premium for stocks. The the presence of dividends on the stocks can nuance that the premium received depending on when the did is expected to be paid.

But that's the essence of the strategy, buying investment and sell call option on that investment, collect the premium incomes, collect the dividends and interest on the underlying stand, hope that the investment doesn't go down in Price. If we look at the top covered call etf in U S, the the largest one is the global x next at one hundred cover call etf that we've already mentioned, Q Y L D. Another large one is the global X S M P five hundred cover call etf X Y L D.

There's a version that is does cover calls on small cap stocks and then there's one which is about nine hundred million dollars in assets. T L T W. It's the I shares twenty plus year treasury bond buyback strategy, p etf.

This doesn't involve dogs at all. IT involves selling options on T, L, T. This is a bond etf.

对， invest in long term treasury bonds. You can self option on this etf. And the Price of T, L, T fluctuate based on what interest rates do. Interest rates go up, the value of T, L, T falls. And when interest rates fall, the value of T, L, T goes up.

Since this is a covered cost strategy, when interest rates fall, then the cost option will go up in Price, and the sell of the option will have to pay a claim cash to the buyer of the option. In looking at the pricing uh of call options on T, L, T, I was surprised to see the potentially the option premium is equal to two point two percent of the notional amount. The underlying investment that's potentially a twenty six percent return per year, just an option premium, plus you get the interest income from only those long term bonds, which right now is over four percent.

So in a perfect world, if T, L T just stayed at its current Price, didn't change, discovered costal energy could turn over thirty percent per year. But we know that just not gonna a happen. If interest rates go up, the Price of T, L, T falls and the return would equal the premium receive plus interest.

But also, since we have the underlying investment that we have in T L T, we would suffer the loss from the value of the etf following this etf was just launched in late twenty twenty two. And if we look at the returns in twenty twenty three T L T, the etf that's investing in twenty years plus treasures bonds return two point eight percent. T L T W the covered call etf based on T L T returns zero point eight percent.

So IT under perform T L T in twenty twenty four year to date, T L T is fAllen five point six percent. Interest rates have gone up and T L T W has return negative two point eight percent. So it's done Better. I have a hard time concept zing how T L T W will do because it's not as intuitive than covered cost strategies on using stocks, at least for me now you might not find covered call strategies intuitive tive at all.

But traditionally, covered call has been on stocks, but now because it's based on etf, we have the scenario where, again, we're receiving the premium income and the interest income, but we have exposure to the downside of the underlying investments with interest rates go up. There is also covered call strategies based on hio bondy tf H Y G W is I shares version and again IT lage the underlying high your bond T F by about four percent tage point and twenty twenty three is out form by about one point eight percent in twenty twenty four year today. But it's it's still early, so we'll see how they do.

Let's then, as we wrap up, turn to the J P Morgan equity premium income etf. J E P I. This is not a plane vanilla cover cause strategy because IT doesn't own the S M P five IT owe a different stock portfolio to more defensive portfolio made up of a hodder and eighteen holding.

So you're earning the dividends on that and potentially some return because instead of writing covered call options, J P. Morgan enters into what are called equity linked notes or s in the equity link notes are private contracts that mimic writing covered call options on the S M P five hundred, but IT is separately negotiated contract. So there is the potential counterparty risk and recognize that the receiving option premium on this note, but they also have exposure to the upside of the S M P and their underlying stock.

Portable folio may do Better than the S M P, but IT may do worse. And so there are some additional moving parts with J, E, P. I try and actively manage fine and not a passive E T.

A. But it's done Better than a traditional S M P five hundred bye etf over the past three years of return, nine point five percent analyzed versus the investigation. S M P five hundred byrde etf, which did five point seven percent analyze, and the global X S M P of one hundred covered call etf, which returned five point three percent, analyze.

So if it's done, almost four percentage points Better analyzed. The underline structure is the same, but IT appears that the underlying investment portfolio perform Better than the S N. P. So it's added some additional return above that.

So it's a reasonable expectation for covered cause strategies recognizing we get the premium income, we get the dividend or interest income, but we have exposure like an insurance company paying out claims if the underlying investment goes up in Price and were exposed to the downside of the underlying investment. We look at historical a returns six to seven percent analyzed is reasonable for cover call strategies based on stocks and stocks etf for cover called strategies based on bonds. It's a little unclear.

These are still new and there's a lot of moving parts. So well, have to wait and see on that one. Now, I had exposure to a cover call, like strategy, the wisdom tree.

Put right strategy, fun. Take A P, U, T, W, wounded for a number of years. Now it's a little different, but instead of selling call options, it's selling put options to IT is receiving premium income.

But in this case, a put option. The claim that needs to be paid is not like a call option. When the underlying investment goes up in prize, you pay out the claim if the falls.

So with P, U, T, W, you're getting the premium income that you return, but then you're reducing a return if the index falls because you're having to pay out these options. Claims and the analyze return has been eight percent over the past five years. So it's done Better than covered calls.

Strategies is a little different. I've discussed another podcast. We won't go into a huge amount of detail, but I I like these income strategies involving options because there are a different return driver, there are a diversifier.

They're a way to generate income that that's different. And again, six to seven percent analyzed return is reasonable. There can be drawdowns of fifteen and twenty percent or more.

So if it's not like they can't lose money, the income receive the premium incomes tied to volatility. So the higher the volatility the implied volatility of vicks, the greater the premium income received. That can vary over time.

But as A A long term diversifying strategy, covered call etf are attractive and something to consider in your portfolio. That episode four seventy one. Thanks for listening. You may be missing some of the best money for the rest of us. content. Our weekly insider guide email newsletter goes beyond what we cover in our podcast episodes and helps elevate your investment journey with information that works pressed in, written in visual formats.

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