Options Overview
To explain covered calls, you have to have a basic understanding of options. An option is exactly what it sounds like – a choice. It’s a contract that gives you either the right to buy (call) or sell (put) the stock at a specific price (strike price) by a certain date (expiration date). If buying an option, you pay a premium upfront to have the option to call or put a stock in the future.
What are Covered Calls?
A covered call is an options strategy. You buy (or already own) a stock, then sell call options against the shares. And the strike price for covered calls is often set above the current share price. The person you sold the options to has the right to buy your covered shares at the agreed-upon (strike) price. For entering into that agreement, you get paid cash upfront that is yours to keep. But if your shares go over the strike price at or before expiration, your shares might be called away.
Selling Covered Calls Example
Selling covered calls is a solid passive income strategy.
A call is an option that gives the buyer the right to buy a stock by a certain date at a specific price. On the other side, the call seller is required to sell shares at the agreed upon price. That’s if the buyer chooses to exercise their option to buy the shares.
Let’s say you own a stock that is trading at $39. You could sell a call with an expiration date in July and a strike price of $39 for $1.55 per share.
That means you are selling the right for the buyer of the call to buy your shares of the stock for $39 anytime between now and the third Friday in July. (Most options expire on the third Friday of the month.)
As a result, you will receive $1.55 per share, or $155 for every 100 shares. (Options contracts are made up of 100-share blocks.)
If the stock does not reach $39, your buyer will not buy your stock and you keep the $155. If the stock is above $39, the buyer will buy your stock by expiration. You can always buy back the call before the buyer acquires your stock, if you don’t want to part with your shares.
This strategy generates income and gives you some downside protection. If the stock falls to $37.45, you’re still at breakeven because you’ve collected $1.55 per share.
Now let’s go over some more benefits of covered call ETFs.
The Benefits of Covered Call ETFs
Understanding covered calls isn’t rocket science. But it is more complicated than other popular investing strategies. As a result, many investors steer clear of covered calls.
One benefit of covered call ETFs is that investors don’t have to rack their brain. The ETF does the work for you. All you have to do is buy the fund, and the fund managers enter into the covered call contracts for you. It’s one of the best ways to profit from covered calls without having to buy the contracts yourself.
Another benefit of covered call ETFs is that they receive more favorable tax treatment. A transaction from a covered call ETF is taxed 60% long-term and 40% short-term. Whereas a single stock option would be taxed entirely on the short-term.
Perhaps the biggest benefit of covered call ETFs is that covered calls provide you exposure to the market with a lower degree of risk. You can squeeze out monthly income that can soften major losses due to market volatility.
Covered Call ETFs Downsides
Similar to other funds, covered call ETFs come with management fees. Fees can add up and take a significant chunk out of your earnings. A 0.8% fee doesn’t sound like much, right? But if you invested $100,000, the fee would be $800 a year. Investors must evaluate the cost tradeoffs.
Also, you could miss out on big returns. Covered call ETFs are designed to mitigate risk to some degree. So, while you dampen big losses, you may miss out on big gains.
Top 3 Covered Call ETFs for 2019
- The Global X Nasdaq 100 Covered Call ETF (Nasdaq: QYLD) is designed to offer investors potential monthly income while mitigating some risks of investing in a major U.S. index directly. All of QYLD’s covered call positions are in the Nasdaq 100. The fund buys equities in the Nasdaq 100 and then sells options to a counterparty that will expire in one month. At the end of the month, QYLD seeks to distribute a portion of the income to the ETF shareholders. The QYLD is a popular covered call ETF.
- The Horizons S&P 500 Covered Call ETF (NYSEArca: HSPX) is another popular and successful covered call ETF. As the name implies, the HSPX write covered calls on securities within the S&P 500. Many people invest in S&P 500 stocks, but too few take advantage of this covered call strategy.
- While the Nasdaq is tech focused, and the S&P 500 is retail heavy, the Credit Suisse X-Links Gold Shares Covered Call ETN (Nasdaq: GLDI) focuses on gold sales. GLDI adds a new wrinkle to the covered call ETF landscape. The ETF offers one-month call options for investors looking to make a profit quickly. The GLDI is a great covered call ETF option for investors looking to profit from gold mining stocks.
Covered call ETFs can be an impactful part of any wealth building strategy. But, there are many more ways to profit with options. You can learn more about trading options here.
Good investing,
Peter