Selling covered calls presents an enticing opportunity to enhance your income stream from your stock holdings.
To illustrate, if you possess Apple shares and believe that a suitable selling price for them is $200, you may opt to sell call options with a strike price of $200. Should the stock price indeed surpass $200, the options may be exercised, resulting in the sale of your Apple shares and realizing your profits.
However, if the price remains below $200, the options will expire without value, allowing you to retain the option premium. This strategy enables you to extract additional yields from your stock investments.
So, should everyone sell covered calls since it sounds like free money?
While it may increase the cash flow generated from your stock portfolio, it might not necessarily increase your overall returns.
Several covered call ETFs are available, permitting us to compare them with the original ETFs.
First, I assessed the performance of the Global X S&P 500 Covered Call ETF (XYLD) against the S&P 500 ETF (SPY) over a nine-year period. SPY delivered an annual return of 11.7%, whereas XYLD yielded only 6% per year.
Next, I compared the Global X Nasdaq 100 Covered Call ETF (QYLD) to the Invesco QQQ Trust (QQQ). A similar pattern of underperformance emerged, with QYLD generating a lower annual return of 6.8%, while QQQ outperformed with a 17.3% annual return.
Lastly, I examined the small-cap arena using the Russell 2000 index. The Global X Russell 2000 Covered Call ETF (RYLD) also fell short of the plain vanilla iShares Russell 2000 ETF (IWM), delivering a 1.6% annual return compared to the latter’s 4.9% annual return.
Hence, it is not evident that selling covered calls can yield higher returns. This is primarily because a stock can appreciate significantly beyond your expectations, but once it surpasses the strike price, you forfeit participation in further gains. In essence, selling covered calls caps your upside potential, transforming an equity investment into something more akin to a bond.
While it is true that selling covered calls can generate increased cash flow from your investments, what truly transpires is that you receive a substantial portion of your total return through option premium collection. Covered calls do not generate additional returns; this is a misconception. In fact, they significantly limit upside potential, especially during bullish market conditions.
Therefore, I believe this situation resembles another Occam’s Razor scenario, where a simpler approach prevails as the better choice.
