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SELLING COVERED calls can sound like a winning investment strategy, especially to yield-hungry investors frustrated by today’s low interest rates. Wouldn’t you know it? There are exchange-traded funds (ETFs) designed to mimic the strategy.
For background, covered calls are a yield-enhancement play that involve selling call options against stocks that you own. The call option gives you extra income, but—during the life of the option—your gains are capped at the call option’s strike price. Essentially, you give up the possibility of scoring big gains but receive extra income in return. If the stock goes nowhere—or even if it rises slightly—you get the call premium while still hanging on to the stock.
I was shocked when I saw the 2021 performance of Global X Nasdaq 100 Covered Call ETF (symbol: QYLD) compared to that of the Invesco QQQ Trust (QQQ), which tracks the Nasdaq 100. The Global X fund was up a paltry 10% last year, while the Invesco ETF soared 27%.
To be fair, selling covered calls is a fine endeavor so long as you fully understand the wager you’re making. During periods of sharply rising stock prices, selling away your upside potential is a losing strategy. But when a sideways or bear market strikes, collecting premiums by writing calls should outperform simply owning the shares outright.
Tempted to write covered calls? Keep in mind that trading options will likely be a wash over the long run, since options are a zero-sum game. It might even cost you because of the money lost to bid-ask spreads and to any commissions you pay. Perhaps more important, your best-performing stocks will likely be “called away”—and history tells us that a small number of huge winners account for much of the stock market’s gains.
I like covered calls, but I think of them more as a kind of bond surrogate and stock de-risker rather than as a complete stock substitute – the risk\return sits between pure stocks and low-yielding bonds. A significant allocation of covered calls has given me comfort to remain nearly fully invested in stocks.
If looking mainly for “yield enhancement” with stocks that go “sideways”, I would also recommend less volatile dividend stocks versus the more volatile and often higher growth Nasdaq stocks. Nasdaq calls do pay more, but the potential upside forfeited is also higher.
Still, I think there can be a place in the portfolio allocation for stocks, stocks with covered calls, and bonds.
Why would the author be “shocked” by the disparity in share price performance between QYLD and QQQ, given that QYLD yields 11.8% while QQQ yields just .46%? The former fund is designed to generate income whereas the latter is designed for growth. Seems like an apples vs. oranges comparison.
Yeah, I figured QYLD would have underperformed, but that return difference just seemed huge to me.
Giving up 17 percentage points of return seems pretty shocking to me — and highlights the downside of writing covered calls.