[Editor’s Note: Options strategies can be complex. As such, they suit more advanced investors who understand the features, benefits and risks of using options. Covered calls are a popular options strategy, but much depends on your market view. This strategy works best in flat or choppy markets, and can limit gains when markets rally. Take the free online ASX options course before using options for the first time. Also, understand the features, benefits and risks of using Exchange Traded Funds for covered call strategies. ETFs can be a convenient way to invest in a diversified basket of options over ASX 200 companies. But like all investments, covered call ETFs have risks. They can potentially have negative returns in some market conditions. Talk to a licensed financial adviser or do further research of your own before acting on themes in this article].
 

A question every investor should ask at the beginning of their investing journey and revisit each year is “what are my goals with this investment?” 

An investment goal can be as broad or specific as you like, but it will generally fall into two overarching buckets – capital growth or income.

If income is your goal, covered call Exchange Traded Funds (ETFs) can potentially help a portfolio’s yield potential and diversify income streams away from dividends and bonds. 

Moreover, covered call ETFs can expand the geographical reach of your income allocation by tracking major US-based indices.
 

Diversifying Income

Diversification is one of the top rules of investing, as it helps to ensure your portfolio is equipped to handle market dislocations and volatility. 

The same can be said for income sources. However, this can be challenging as the yields paid by overseas shares are significantly lower than those from their Australian counterparts. 

To compare, let’s look at the average annual yields from some major indices, including the S&P/ASX 200, S&P 500 and Nasdaq 100. 

As can be seen below, sourcing income from overseas markets is decidedly more difficult, due to the high yield standards set here in Australia [Editors’ note: Franking is another consideration for income investors]

Source: Bloomberg, for S&P 500 and Nasdaq 100 using US ETFs yields gross of fees.
 

The US-based indices offer lower yields because they are weighted more heavily to large-cap technology stocks which are more likely to reinvest their capital than share it with investors in the form of dividends. 

Meanwhile, materials and financial stocks which dominate the S&P/ASX 200 have historically passed along their winnings to investors. 

There are also some tax benefits to enacting buybacks over dividends in the US, hence significant buybacks are more common in that market and in some instances staggering amounts are bought back by companies. All in all, this can be a disadvantage to income-focused investors in Australia.
 

Alternative Income

Most investors access passive income (income not derived from working) through property, shares and cash. According to SMSF data from the Australian Taxation Office, 30% of SMSF investments sit in shares, with a further 15% in cash [1]. This indicates that many Australians who are focused on income, such as SMSF investors, are using shares and the benefits of Australia’s imputation credit program (franking) to generate income.

Whilst this is a valid approach, the need to diversify income sources from more traditional asset classes (like those mentioned above) could be beneficial in choppy markets or during recessionary times. This is why covered call strategies have been popular here and offshore as they help generate additional income, while still giving access to share dividends and if invested over Australian shares, can include those prized franking credits.
 

What are Covered Call Strategies

A covered call strategy involves buying a stock or basket of stocks and selling a “call option” on those securities. Selling a call option forfeits the upside potential on those underlying stocks if it’s written at-the-money (ATM).

In exchange, the investor receives a premium for selling the call option. Therefore, a covered call strategy can be used to generate additional income from equities.

This can sound complicated and therefore, for many investors, is put into the “too hard” basket. However, as with a huge range of other asset classes and geographies, ETFs make it much easier to access these strategies and help local investors generate income in one simple trade. 
 

What Market Scenarios Work Best for Covered Calls?

Covered calls are best placed when markets are range bound, but tend to underperform when are markets are strong. This is happens because ATM covered call strategies cap the upside due to their focus on income generation over growth. 

The diagrams below illustrate how ATM covered calls perform in different markets:

Source: Global X
 

To further demonstrate this point, it is best to look at some real historical numbers, which depict the total return of an index (capital growth and income combined), for the two largest US-based indices. 

The table below shows how, during a tough market such as 2022, covered call indices outperformed significantly. 

Conversely, in strong up-markets such as 2021 and the current year to date, a market cap index will outperform on a total return basis.

Source: Bloomberg, Data as at 14/7/2023, converted to AUD
 

To purely assess the income outcomes, the table below examines the yields of each index. It highlights the significant component of the returns for those years bringing in consistent and highly elevated yield in comparison to the underlying index. 

This indicates that the income component of the total return makes up significantly more compared to the capital growth portion. 

Source: Bloomberg, Data as at 30 June 2023.

Key risks

Before using covered call ETFs, investors should ensure they understand covered call option writing risk. By writing covered call options in return for the receipt of premiums, these strategies will give up the opportunity to benefit from potential increases in the value of the underlying index above the exercise prices of such options, but will continue to bear the risk of declines in the value of the index. This can be seen when markets are strong, as shown in the above table for the Nasdaq and S&P 500.
 

Right Tool for the Right Market 

Ultimately, the outperformance or underperformance of a covered call strategy relies on market conditions. Still, the yields can remain consistent across different styles of markets – making them a consideration for investors seeking income.

Covered calls can potentially be added to a portfolio as an income satellite that supplements your existing income generating assets, in Global X’s opinion. 

However, covered-call strategies should not be used as a replacement for the portfolio’s growth portion and/or the underlying index that they represent. 

Whether they are written over international or local indices, covered call ETFs are designed to support those seeking income from their portfolio. 

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[1] ATO, SMSF data