The question
Some ETFs pay 10% a year in cash. Where does it come from, and what does it cost me?
The idea
- A call option gives its buyer the right to buy something at a set price, the strike, until a set date. The seller is paid up front, a premium, and in return must hand over any gain above the strike.
- A covered call fund owns the stocks and sells calls on them. So, in advance:It keeps the premium whatever happens. That cash funds the big payouts.It gives up gains above the strike. That is the cap on the upside.It still owns the stocks, so it takes the losses, softened only by the premium.
- Hypothetical: the index is at 100 and the fund sells a one-month call at 100 for a premium of 2.Index ends at 105: the fund keeps 2 and hands over the 5. Return: +2%.Index ends at 100: it keeps 2. Return: +2%.Index ends at 95: it loses 5 and keeps 2. Return: −3%.
Worked example
The 4 steps beside the drawing at the top work this through on ETFIQ data. Point at a step to light the part of the drawing it describes.
XYLD owns the S&P 500 and writes (sells) calls on it. Its benchmark is SPY. Totals below assume the cash was reinvested, so they don't equal cash plus price exactly.
On a hypothetical week: SPY +2% means XYLD about +2% × 0.513 ≈ +1.0%; SPY −2% means about −2% × 0.71 ≈ −1.4%. It gives up more of the gains than it saves on the losses, in exchange for steady cash.
The common mistake
"Option income protects me in a fall." The premium softens a fall only by its own size. XYLD took about 71% of SPY's weekly falls while catching about half its rises. A covered call trades upside for cash; it is not insurance.
Check your understanding
Pick an answer to see why. Two of three right passes the lesson.
1. What does a covered call fund give up in exchange for the premium?Answer: A. Gains above the strike. the call's buyer takes any rise above the strike. Not C: the fund still owns the stocks, so it keeps the losses.2. A fund owns a stock at $50 and sells a one-month call at a $50 strike for $1 (hypothetical). The stock ends the month at $56. What does the fund make per share?Answer: B. $1. it keeps the $1 premium and hands over the $6 rise above $50. Not D: $7 would mean keeping both the rise and the premium; the rise belongs to the call's buyer.3. A fund's upside capture is 50% and its downside capture 70%. The market rises 4% one week and falls 4% the next. About what does the fund do each week?Answer: D. About +2%, then about −2.8%. 4% × 0.5 = 2% up, then 4% × 0.7 = 2.8% down. Not B: it gives up half of each rise but avoids only 30% of each fall.
Takeaways
- A covered call fund's cash comes from selling away the upside.
- It lags in strong rises and cushions falls only partly; read its upside and downside capture.
- Judge it on total return against its benchmark, not on the payout.