Best Stocks For Covered Call Writing

If you're looking for a pure high yield in today's markets, one of the first places you should look is in covered calls. These are the strategies that generally replicate an index or basket of securities and then sell call options on either part of or the entire portfolio in order to generate a high income. Many closed-end funds also utilize a covered call strategy, but they tend to be hampered by the use of leverage and unsustainable distribution policies that can hurt total returns. If you want a covered call strategy in its purest form, ETFs are still the way to go.

There are downsides, though, to covered call strategies. The biggest is that they only work in fairly specific environments. The best would be one where stocks are moving sideways or slightly down with low volatility. In this case, the options likely expire worthless allowing the option seller to collect the full premium without any significant negative impact from the share price.

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High volatility, however, is a covered call strategy's enemy. In this case, there's a higher likelihood that the call option would be exercised by the buyer forcing the call writer to sell shares at below market prices. Also, since markets tend to rise over time, calls originally written at-the-money or even slightly out-of-the-money will tend to be called away more often than not.

Covered call strategies generally don't provide much downside protection either. They generally only outperform by the yield premium. During the COVID bear market of 2020, the S&P 500 fell more than 30%. Covered call strategies using the S&P 500 as their benchmark index did slightly better, but were still down 25-30% themselves.

The recent market environment, however, has shown how effective covered call strategies can be. They've hit that sweet spot of sideways market movement with low volatility and during the month of September alone have outperformed the indexes by nearly 2%. That's in addition to collecting a juicy double-digit annualized yield.

If you're looking to take a little risk off the table here and are enticed by the idea of adding a 10%+ yield to your portfolio, here are three covered call ETFs that will do just that.

Global X S&P 500 Covered Call ETF (XYLD)

XYLD follows a fairly straightforward strategy. It replicates the S&P 500 by owning all of the index's individual components in substantially the same weightings, while writing call options equivalent to 100% of the portfolio's value. The options have one month until expiration and are generally written at the money.

With volatility remaining low throughout the majority of 2021 and stock prices steadily rising without so much as a 5% pullback in the S&P 500, covered call ETFs have underperformed as would be expected in such an environment, but look at what's happened in September.

The white line in the chart is the ratio of XYLD to the S&P 500. During September, large-cap prices have gently drifted lower, while the VIX has been mostly below 20 consistently since May. Those are exactly the right kind of conditions for covered call ETFs and you can see how XYLD has performed.

If you're a long-term investor looking for capital growth, XYLD probably isn't the best choice since it likely will underperform over time. If you're looking for high income and are willing to pass up on the opportunity for most capital growth potential, XYLD is a better option.

Global X Nasdaq 100 Covered Call ETF (QYLD)

This works on the same strategy as XYLD, but uses the Nasdaq 100 as its underlying index of choice. This fund is one of the most popular in the Global X lineup due to its ties to the tech sector and how well this index has done over the past several years. While the fund has struggled in 2021 thanks to the excess volatility that's hung around tech stocks this year, the last month has proven to be quite fruitful.

Relative to the Nasdaq 100, QYLD is back to its highest level since June. This fund I think could have a little more trouble not getting dinged since there's more volatility in the tech sector and that's the type of thing that leads to covered call strategies struggling. On the flip side, the Fed continues to support the economy and that has generally led to good things for stocks and if things go sideways, the 10% yield being kicked off by QYLD can add a little comfort. This might especially be the case for those living off of portfolio income since this fund has paid consistent monthly distributions for almost 8 years.

Global X Russell 2000 Covered Call ETF (RYLD)

We've talked about options for both the S&P 500 and the Nasdaq 100, so we might as well wrap this up by covering a Russell 2000 covered call ETF as well. This also utilizes a 100% options overlay strategy, but currently kicks off a 12% yield, making it not just one of the highest yielding covered call ETFs around, but one of the highest yielding ETFs period.

Small-cap stocks have had their troubles in 2021 and the past month or so has featured a mixed bag of performance. That's given RYLD, which feasts on the uncertain direction of equities, a good opportunity to pull ahead of its underlying index.

Conclusion

Those considering adding a covered call ETF to their portfolio have to come to terms with the following outlook for the investment - it'll probably come with very little, if any, capital growth potential and the source of returns will mostly come from the income generated by the option contract sales.

In that sense, they're a much more conservative option than a traditional equity ETF, but offer a higher yield potential than a straight income fund. Over the past five years, the covered call ETFs have earned roughly half the return of the underlying index - 9.5% annualized for XYLD vs. 18% for the S&P 500 and 12% for QYLD vs. 27% for the Nasdaq 100. Still, those are strong returns for an income-focused strategy and it follows through on the idea of "mostly income, little capital growth" nature of the funds' return profile.

With both large-caps and Treasuries still yielding less than 2%, the Global X lineup of covered call ETFs might be worth a look even in modest doses if you want a yield boost.

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