Covered call ETFs offer the combination of investment exposure to a selected index, plus high-yield income from selling call options. I am considering a tactic for this type of fund that should help boost total returns.
Last month, I made a presentation at the Las Vegas MoneyShow covering covered call ETFs. I discussed how they work and the pros and cons of a dozen funds that employ option-selling strategies. While preparing, I noticed a potential problem and have been thinking about a solution.
A solution that could boost your investing returns…
The covered call strategy involves selling call options backed by owned or purchased shares. In my MoneyShow presentation, I used this example:
United Airlines (UAL) at $45.86, June 9 $49.00 calls at $1.00.
The covered call trade would be to buy UAL (in 100 share lots) and sell the call options. The option premium gives a 2% cash return in roughly 30 days. If UAL is below $49.00 on June 9, the calls expire worthless, and more calls can be sold the following week. If the stock is above $49.00, the call will be automatically exercised, and you will receive $49.00 per share, giving a $4.14 per share, or about 9%, total return in 30 days.
To recap, covered call trades provide current cash income from selling the calls but also cap the possible capital gains.
Covered call ETFs use the same strategy, typically with a popular index as the underlying asset. For example, the Global X NASDAQ 100 Covered Call ETF (QYLD) sells call options against the Invesco QQQ Trust (QQQ). These funds sell monthly options and also pay monthly dividends. Yields can be very attractive. The QYLD webpage reports a distribution yield of 11.7%.
The challenge to investing these funds is that, after a downturn, it is tough for the share price to recover. Gains are capped each month. In a volatile market, such as we have experienced over the last year, a covered call ETF will significantly underperform the underlying asset. Since May 1, 2022, QQQ has returned 2.30%. Over the same period, QYLD posted a 0.3% total return, which, combined with 12% in dividends, means the share price dropped by almost 12%. Year to date, QQQ has returned 21.8%. The QYLD share price is up 9.8%, plus about 5% in dividends received.
However, I continue to like covered call ETFs. I think a tactical approach will boost returns significantly. Here are the steps:
Starting with an initial dollar amount of the fund, buy back up to your base if the value drops by 5%, and sell 5% when the value exceeds the base by that amount. Take dividends as cash, do not reinvest.
For example, you start with $10,000 in QYLD. If the value climbs to $10.500, you will sell $500 worth of shares. If the value drops to $9,500, you will buy $500, bringing the value back up to $10,000.
This strategy lets you trade intermediate market swings and should produce returns superior to a buy-and-hold position.
