Equity investors must currently contend with soaring valuations, concentration risk, volatility, and more within stocks. As more investors look to alternatives for opportunity, covered call ETFs prove increasingly popular, and for good reason.
Option strategies, once considered too complex and niche for most investors, now enjoy mainstream adoption. Covered call strategies, wherein a fund writes and sells calls on underlying equity holdings, thereby earning income (premium), have grown in popularity over the last decade. Since 2022, when stocks and bonds both underperformed, it’s been a veritable renaissance for covered call ETFs.
“It’s going to give you an alternative income away from just long, core equities or fixed income,” explained Garrett Paolella, co-founder, managing partner, PM, NEOS Investments. “They’re meant to be more on the conservative side.”
Paolella joined Eric Granat, CAIA, PM, derivatives analyst, Fidelity Investments, and Todd Rosenbluth, head of research, Vettafi, in the 2024 Alternatives Symposium hosted on the VettaFi platform.
Income Generation Without Added Credit, Duration Risk
Covered call strategies work across a variety of market environments. In moderately up to flat markets, they boost income potential for a portfolio. In down markets, premiums may reduce some losses, but the strategies are not a loss mitigation tool.
Income derived from options strategies offers several potential benefits beyond those of bonds.
“Option income, depending of course on the fund and the type of option used, can bring certain characteristics of tax efficiency,” stated Paolella. This includes “converting a lot of [the income] to long-term capital gains treatment, a mix of long-term/short-term, or even sometimes a return of capital tax designation.”
When comparing income potential of options ETFs to bonds, high yield ETFs and more, covered call ETFs often rise above. Paolella explained that most covered call funds currently yield between 5%-15%. For comparison, high yield [junk] bonds currently yield around 6%-7% and mean taking on added credit risk exposure.
“These option strategies and covered calls can really bring healthy income to the portfolio,” said Paolella.
Covered Call ETFs Benefit During Elevated Volatility
Covered call ETFs like the NEOS S&P 500 High Income ETF (SPYI ) and the NEOS Nasdaq 100 High Income ETF (QQQI ) also benefit during periods of elevated volatility. “As market volatility increases, you’re able to generate more income — more higher options premium,” Paolella explained. It makes strategies like these a potential boon to portfolios when volatility rises.
SPYI seeks to provide exposure to the S&P 500 while generating high monthly income for investors through call options. It uses money earned from written calls to buy long, out-of-the-money call options on the S&P 500 Index.
An out-of-the-money call option has no intrinsic value. That’s because the current price of the underlying asset is below the strike price of the call. Should equities rise or fall, NEOS can actively manage the call options to capture gains in the underlying assets or minimize losses.
The options that the fund uses are index options, taxed favorably as Section 1256 Contracts under IRS rules. Options held at year’s end are treated as if sold at fair market value on the last market day. Any capital gains or losses are taxed as 60% long term and 40% short term, no matter how long investors hold them. This can offer noteworthy tax advantages. SPYI has an expense ratio of 0.68%.
QQQI employs a similar strategy but within the Nasdaq-100. The options that QQQI uses are call options on the NDX and qualify as section 1256 contracts.
Should equities rise or fall, NEOS can actively manage the call options to capture gains in the underlying assets or minimize losses. QQQI has an expense ratio of 0.68%.
In addition, both funds also engage in tax-loss harvesting opportunities throughout the year on the call options, equity holdings, or both.
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