Covered call ETF strategies

In recent years, covered call strategies have become more popular in the ETF market. Covered call strategies have taken their place alongside dividend strategies and low-volatility strategies as ways to potentially generate income and reduce some of the risks of holding equities. In this article, we explain how a covered call strategy works on a single stock that you own in your portfolio. We also explain how the strategy works on a group of stocks when you hold a covered call ETF. We conclude with a caution about covered call ETFs that offer very high payouts.

What’s a covered call?

In a covered call strategy, an investor sells a call option on a stock or ETF that they already own. The covered call investor generates some income from the strategy, because they receive the premium from the call option they’ve sold. This premium income can help reduce losses if the stock price falls. But it’s not free money. The covered call investor has given the buyer of the option the right to buy the shares if the stock reaches a given price — the strike price — on or before a given date — the expiry date.

Covered call strategy on a single stock

Let’s use this illustrative example to see how a covered call works on a large upside or downside move in the stock price.¹

Let’s say a stock’s price is at $100 at the time of selling the option. The option strike price is set at $110, at an option premium of $2. The call option’s expiry date is in 6 months.

Total payoff on a large upside move: Stock price increases to $120

The $2 option premium, plus a $10 realized gain on the stock, equals a gain of $12.

This assumes the stock closes at $110 or higher at option expiry.

The covered call investor will be assigned or forced to sell their stock at the strike price of $110, when the stock price rises above the strike price.

Total payoff on a large downside move: Stock price decreases to $80

In this case, the $2 option premium, minus a $20 realized loss on the stock, equals a loss of $18.

This assumes the stock is sold at $80.

From these examples, we see that:

On a large upside move, the covered call can leave money on the table.
On a large downside move, the covered call may not provide much protection.

Bottom line: The covered call strategy works best when the stock price is flat or moves only moderately. In this example, the best outcome for the covered call investor is when the stock price reaches $110. The investor hasn’t given up any upside beyond the strike price of $110, plus they picked up an option premium of $2. Nice work if you can get it.

Covered call ETF strategy

Investors can also buy ETFs that apply a covered call strategy to groups of stocks, such as those in a similar sector or industry.² From the earlier examples, we saw that a covered call strategy tends to work best if the stock price is flat or moves only moderately. When an ETF manager picks a group of stocks, it’s relatively unlikely that all stocks in the group will exhibit very large up or down moves for long periods of time, especially if the stocks are selected from stable, dividend-paying sectors. In other words, the performance of a group is likely to be less volatile than the performance of a single company.

If an ETF manager targets a group of stocks with a 5% dividend yield and earns a 2% option premium from covered calls, the fund can target a 7% yield. This level of payout may appeal to investors who like regular income, including those in retirement.

High payouts from covered call ETFs

Investors should be cautious about very high payouts from covered call ETFs, however. Let's continue with the example of a 5% dividend yield and a 2% option premium. If a covered call fund is offering a 10% payout, where does the extra 3% come from?

In some cases, a covered call ETF may use leverage to boost returns. But for now, let's assume the ETF doesn’t use leverage. In this case, there's a chance that the ETF is paying out the extra 3% as a return of capital. A return of capital doesn’t come from cash dividends — instead, it comes from the fund returning a portion of the capital that investors have placed in the fund.³ Think of this as investors being paid back with their own money. This might work for a while as the fund adjusts its cash flows, but it’s unlikely to be sustainable over the long term.

How to check for return of capital? This involves digging into the ETF's financial statements:

Visit the ETF issuer's website, pull up the fund documents and look for the financial statements and MRFP (Management Report of Fund Performance).
Look for a section on financial highlights or similar, which reviews the ETF's net assets per unit.
Look for a breakdown of distributions. This will likely include net investment income (including dividends), dividends, net realized capital gains and return of capital.
Sum the total distributions over a multi-year period and calculate how much comes from return of capital. If this is a significant amount, say more than 10% to 20%, you might want to think about the sustainability of the fund's distributions.

Key takeaways

An investor runs a covered call strategy by holding the stock of a company and selling a call option on the stock to earn an option premium. An investor can also buy a covered call ETF, which applies a covered call strategy to a group of stocks.

Covered call strategies can increase the payout of an ETF, beyond what would be expected from dividends alone. However, investors should be cautious about very high levels of payout, which may signal that distributions are being funded by a return of capital, leverage or both. Investors can check this by examining a fund's financial statements.

¹ In all examples, brokerage commissions are not included.

² While covered call ETFs often target groups of stocks, some target single stocks.

³ Return of capital is not unique to covered call ETFs; it also occurs with other investment strategies, particularly those focused on income. Since payouts from covered call ETFs typically include dividends and option premiums, payouts can look extra high when adding return of capital.