Calling for Yield

IF I SAID YOU COULD corral a yield of almost 12% by holding most of the stocks in the Nasdaq 100 index through an exchange-traded fund (ETF), would you think I’ve been smoking something? Well, you’d be wrong.

Global X Nasdaq 100 Covered Call ETF (symbol: QYLD) has pumped out a humongous dividend for more than 100 consecutive months, ever since its 2013 inception. But first a caveat that many will view as a tragic flaw: QYLD is a pure income investment, one that’s best held in a retirement account. The opportunity for capital gains over the long haul is nil. Indeed, QYLD was off 15% for 2022 through yesterday’s close, though that’s substantially better than the 26% loss for Invesco’s Nasdaq 100 ETF (QQQ), which doesn’t sell call options and instead simply tracks the Nasdaq index.

Let’s begin by reviewing the covered call strategy’s short but checkered history. It’s been controversial ever since its advent in the early 1980s. Seen as a way to garner high income while still enjoying some modest stock market gains, the strategy quickly became a darling of the brokerage and mutual fund industries, thanks to the commissions and fees it generated. But the roaring bull market that took hold in 1982 soon punctured the marketing hype. A long stock position saddled with short options simply couldn’t keep up with a soaring stock market.

How does the covered call strategy work? An investor might establish a covered call by simultaneously buying a stock and selling the corresponding call options. The investor is long the stock but, by hedging with call options, has given up upside in return for the income from selling the calls. How hedged is the investor? That depends on how close the call option’s strike price is to the stock price. The closer those two prices, the stronger the hedge and the less bullish the position. If the prices are very close, the investor will collect a larger call premium, but it’s more likely that the stock will be called away, so the upside is very limited if the stock appreciates.

As you might sense, the strategy has many moving parts and can seem dauntingly complicated. Enter covered call ETFs. These funds are as easy to trade as any other ETF. They come with the well-known perks of low cost and transparency. The covered call rigmarole is done much more cheaply and effectively than you could do it on your own.

Indeed, I believe a lot of the credit for the rejuvenation of the covered call idea belongs to the innovative folks at Global X Funds, which launched the Nasdaq 100 Covered Call ETF. The company now hosts a suite of three additional covered call ETFs, one each for the S&P 500, the Russell 2000 and the Dow Jones Industrial Average. Toss in tiny stock market dividend yields, modest interest rates and a bear market, and—voila—we’ve seen a surge of interest in the covered call strategy. QYLD is the most popular ETF of the Global X covered call group, with net assets ballooning from $4 billion to almost $7 billion in less than a year.

How might you use option-income ETFs in today’s dour market climate? The big attraction, of course, is the 12% current yield. Payouts from QYLD are monthly and reasonably steady. You might reinvest those dividends in additional shares or spend the income, while you wait for the bull market to return.

The potential compounding over many years could be very attractive, especially when we recall that the average total return for stocks over the past century hovers around 10%, plus those returns fluctuate more than that of a covered call ETF. Still, we need to put an asterisk next to that 12% yield. Buyers of call options are willing to cough up higher premiums when stock prices are more volatile, as they are today. When the market calms down, so too will the excess premiums, and QYLD’s yield will no doubt subside to a level closer to the stock market’s historical annualized total return.

The more jaundiced among you may have noticed I’ve avoided labeling the covered call strategy as “conservative.” Option-income ETFs shouldn’t be promoted as conservative. They offer only a partial hedge in a declining market. The option premiums are only large enough to offset part of a market slide. As we’ve seen this year, holders of covered call ETFs lose money in market selloffs, perhaps suffering losses equal to 55% of their benchmark index.

I believe there are two very different covered call ETF strategies that are intriguing in today’s bear market. The first strategy, which I described above, is for investors who are cautious but nonetheless able to absorb much of any further market drop. These investors could either pocket the cash generated by QYLD or reinvest their distributions, letting them compound until the proceeds are needed.

Alternatively, folks could get a little opportunistic. Let’s say an investor thinks the bear market is near exhaustion. His momentum indicators say the turn is not as far away as the pundits think. He might buy shares of QYLD and be showered with dividends while he taps his fingers. When his favorite buy signal hits, he can switch into the real thing—QQQ—or its more docile cousin, the Technology Select Sector SPDR Fund (XLK). Neither fund hedges and both pay only incidental dividends, but they offer a gutsy play on a recovery in tech stocks.

I’ll subscribe to the first idea and hand off the second maneuver to those who consider themselves nimble traders. I’ve been programmed to float like a butterfly, not sting like a bee.

Steve Abramowitz is a psychologist in Sacramento, California. Earlier in his career, Steve was a university professor, including serving as research director for the psychiatry department at the University of California, Davis. He also ran his own investment advisory firm.

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