2020 is, perhaps, the most difficult environment ever for retirees or anyone looking to generate reliable, growing income from an investment portfolio. The 10-year US Treasury is yielding less than 1%1, two-year CDs are at 0.8%2, and US bonds, in general, have a yield to maturity of 1.2%.3
It is natural for people to look for, let’s say, creative ways to get income in this low-yield environment.
One such method involves selling call options to generate “income” (you’ll see later why that is in quotes). The financial wizards at Global X have even cooked up a way to turn the wildly popular Nasdaq 100 into a covered call strategy. That ETF (QYLD) has been the #1 non-traditional ETF requested on my YouTube series reviewing all 18 dividend ETFs.
And I can see why.
The appeal of these funds is clear: underlying exposure to a high-performing index (Nasdaq 100) and a 10.95% distribution yield.4 In an environment where the 10-year US Treasury is yielding less than 1%, does an ETF like QYLD have a place in your portfolio as a bond substitute?
How do covered calls work?
A covered call is essential trading the future upside potential of an investment to someone else in exchange for an option premium. If that sounds completely foreign, you can read more about covered calls and come back later. For the rest of the article, I’m going to assume you already know the basics.
An 11% Yield: Too Good to be True?
99.9% of investors who use a covered call strategy do so for its income. Clearly, covered calls generate massive income. A 11% distribution yield in today’s sub-1% environment is great.
In fact, it’s a bit too great.
And you know the rule-of-thumb for things like that. If it sounds too good to be true, it probably is.
Why would an investment pay 11% in a sub-1% world?
Every investment has another side. If you’re getting paid a 10% premium, you’re getting paid by another party. Why would that other party pay you 10%? What are they getting out of it and, therefore, what are you giving up to get that 10%?
In this case, you’re giving up the upside potential of your underlying investment in exchange for that 10% option premium upfront.
QYLD Income: Real or Not?
Let’s say a business sells $100,000 worth of goods to be delivered in 6 months. They collect all of that cash up front. Would we consider that income?
No, it’s revenue. It only becomes “income” after considering the costs to manufacture and ship the goods. If it ends up costing $100,000, then that initial cash flow never materialized into net income.
A covered call is not dissimilar from this situation. The only difference is that the cost is not explicit. When you sell a covered call, you collect cash flow up front. That cash flow is never taken away from you, which makes it confusing for investors considering covered calls. They only see the 10% gain as income without considering the offsetting expense.
That expense is an opportunity cost. If you write an option and the stock goes up a lot, you will miss out on that upside.
To see how this works, consider how the covered call strategy represented by the QYLD ETF (Nasdaq 100 + covered calls) compares with an investment in the Nasdaq 100 (QQQ) without covered calls.
If you would have invested $10,000 at the start of ETF trading on QYLD5, your investment would have grown to $17,766. That includes the option premium and dividends reinvested. A $10,000 investment in QQQ would have grown to $36,692.
There, we see that the covered call strategy sacrifices mightily on potential upside. In this particular case, the return was half as good. Not only are you giving up the upside, but you’re also retaining the entirety of the investment’s downside.
With a covered call strategy, you retain full ownership of the underlying positions. That means in down markets, you experience (nearly) the full downside of owning stocks. The covered call option premium makes up for some of this, but not much.
If you had $10,000 in QQQ on February 20, 2020, it would have shrunk to $7,299 (-27%) within a month6 QYLD, which is essentially QQQ with covered calls written on it, would have offered little relief. The same $10,000 over the same period would have fallen to $7,469 (-25.3%).
While covered call strategies can offer downside protection relative to an all-equity portfolio, it’s not much. In fact, the downside protection from the covered call strategy was so weak that a tiny (even 10%) allocation to Treasury bonds would have been superior in preventing losses. That small allocation to bonds also wouldn’t give up nearly as much upside as the covered call strategy.7
Does a covered call strategy ever have a place?
When markets are extreme, which they often are, covered calls underperform other strategies. In extreme down markets, the covered call strategy would experience nearly 100% of the downside. In extreme up markets, the underlying index gets called away and then is forced to be repurchased at higher prices.
That leaves QYLD (and others like it) in a challenging position if you’re either bullish or bearish on the underlying investment (QQQ, in this case):
- If you think the QQQ is going to go up a lot in the future, you should own QQQ. QYLD would offer no upside (but all risk) and makes no sense.
- If you think QQQ is going to go down in the future, then you should own something that holds up well when stocks go down.8 Owning QYLD would make no sense because you still retain the downside of QQQ only slightly offset by option premium.
The only possible rationale for a covered call strategy (from what I can tell) is if you think the market is going to go sideways/slightly down for the foreseeable future. If that were to happen, then the 10% option premiums would be greater than both the downside and the foregone upside. You would collect your premiums and never have an offsetting opportunity cost.
That is the environment when a covered call strategy makes sense.
In essence, QYLD is a bet against volatility in either direction. If you think QQQ is going to be not-as-volatile as expected, then QYLD makes sense. Otherwise, I don’t see how it really fits into a portfolio.
- Daily Treasury Yield Curve Rates. https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield. Accessed 11 Dec. 2020. ↩
- Goldberg, Matthew. “Best CD Rates for December 2020.” Bankrate, https://www.bankrate.com/banking/cds/cd-rates/. Accessed 11 Dec. 2020. ↩
- Vanguard ETF Profile | Vanguard. https://investor.vanguard.com/etf/profile/portfolio/bnd. Accessed 11 Dec. 2020. ↩
- ETF.com accessed December 10, 2020 ↩
- 12/31/2013 ↩
- Global X NASDAQ 100 Covered Call ETF (QYLD) Performance, Morningstar. https://www.morningstar.com/etfs/xnas/qyld/performance. Accessed 10 Dec. 2020. ↩
- From 2014–2020, a portfolio mix of 90% QQQ/10% GOVT would have outperformed QYLD in every year but one. And it would’ve done so by a healthy margin. ↩
- This has historically been Treasury bonds. ↩
- Inc, SignalTrend. “ForecastChart.Com.” ForecastChart.Com, http://www.forecast-chart.com/index.html. Accessed 11 Dec. 2020. ↩
- Source: Morningstar ↩
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