First, what is a covered call, anyway?
A call option is an agreement that gives a buyer the right to buy a stock at a predetermined price in the future. The seller is compensated for giving the call option buyer the right (or the option) to buy the investment they own. The option is “covered” if the seller owns the underlying stock. Canadian investors can “write” (sell) a covered call option when they want to reduce the risk of owning an investment.
In 1999, Mark Cuban (the minority owner of the Dallas Mavericks but better known as a panellist on Shark Tank) sold Broadcast.com to Yahoo!, and in return received 14.6 million shares of the company. Cuban was forced to hold Yahoo’s shares (likely due to a lock-in period) and implemented a version of covered calls to protect his position, explains Koivula.
In the example above, Mark Cuban can give another investor the right to purchase one share of Yahoo—let’s say at $100 per share—at a future date. For simplicity’s sake, we’ll assume Cuban’s Yahoo shares are worth $95 each, so he was able to sell the option for, say, $4. Here are two hypothetical outcomes:
- Scenario 1: Yahoo’s shares move up to $110 per share. The counterparty exercises their option to buy at $100, and Cuban has to sell it to them at that price. He misses out on the $15 gain, but still has the $4 from selling the option. Cuban ends with $99 instead of the $110 he would have if he hadn’t sold the option.
- Scenario 2: Yahoo’s shares fall to $90 per share. The counterparty doesn’t exercise the option because they wouldn’t buy shares for $100 that they could buy for $90. Cuban has lost $5 on the value of his Yahoo share. However, the loss has been offset by the $4 premium from selling the option. Cuban ends with $94 instead of the $90 he would have if he hadn’t sold the option.
You can see that the covered call acts as a kind of dampener on the investor’s overall return, while giving them immediate income ($4 in the example above).
What are covered call ETFs?
Most Canadian investors don’t implement options trades. But they can own covered call ETFs. Covered call ETF providers step in to implement this trade on investors’ behalf, with a larger pool of funds. Global X’s S&P 500 Covered Call ETF (XYLD) is a well-known example of a covered call ETF. In Canada, examples include RBC’s Canadian Dividend Covered Call ETF (RCDC) and CI’s Gold+ Giants Covered Call ETF (CGXF). Use a Canadian ETF screener to find more.
Why are covered call ETFs gaining traction?
Many Canadian retail investors are seeking the highest dividend or yield that they can find in an ETF. In many cases, covered call ETFs come up near the top of that search, says Koivula.
Some of his own clients see covered call ETFs offering eye-popping yields, and they decide to further investigate the opportunity. Indeed, as of Feb 14, 2024, XYLD paid a 10.6% 12-month trailing yield, which, on face value, is a very strong income yield.
ETFs like this can work well in the short-run. Koivula points out that clients like that they’re “getting paid to wait” if they think markets will be flat or down.
Jun Ho
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