Uncovering covered calls

As income remains a top priority, Australian investors are increasingly exploring covered call strategies for reliable cash flow and to manage volatility. We wanted to lift the lid on this popular investment strategy, dispelling some common myths, and reveal the potential benefits of employing covered call ETFs into portfolios.

Key Takeaways

• Although covered call strategies may have limited upside capital gain potential, they have proven resilient by helping to reduce market drawdowns and can experience strong recovery phases.
• While the enhanced income from selling call options premiums may not centre on tax optimisation, covered call strategies can offer some tax advantages, such as access to franking credits.
• Covered call strategies don’t inherently compromise long-term returns. An Australian covered call strategy has historically outperformed the broader Australian market over the long run while maintaining a lower volatility profile.

Popularity of Covered Call ETFs

Considering one of Australian investors’ primary focus is on generating and sustaining income1, it’s no surprise that covered call ETFs have risen in popularity. Having first launched in Australia in 2012, the recent flows combined with new products coming to market, have propelled the Australian-listed covered call ETF industry to be worth almost AU$4 billion (representing less than 2% of the entire Australian ETF market). This is just a fraction of the US-listed covered call ETF industry worth over US$70 billion (representing less than 1% of the entire US ETF market).2

With the ASX 200 dividend yield falling from 4.5% to 3.5% over the past year, and Australian bonds offering yields of around 4-5%3, investors who are starved for income may look to covered calls, which can pay income yields of around 8% to 12% per year.4

There has been an increasing number of conversations amongst clients about the nuances of covered calls, including dispelling some common myths. In this article, we dive into three key myths and address each one to uncover the power that covered call strategies can provide to investment portfolios.

Myth 1: Covered Call ETFs Lag in Recovery Markets Given Their Limited Upside

Covered call strategies tend to outperform when markets fall as the income derived from writing the call options can act as a buffer to help cushion the fall in equity prices. This is evident in the below drawdown chart, and with an average downside capture ratio of 0.435, it highlights the strategies’ successful nature in minimising loss relative to a benchmark during down-markets.

Some believe that because a covered call ETF has a capped price upside, the strategy cannot benefit from a market recovery. However, this isn’t necessarily the case. The cap occurs because when an at-the-money call option is written, the strike price is set equal to the underlying asset’s price. If the underlying index price rises above the strike price, the call option buyer can exercise the option, meaning the seller (the covered call writer) misses out on any additional upside.

However, covered call strategies write call options with either monthly or quarterly expirations. This structure allows for participation intra-month or intra-quarter in a recovery market, even after a market drawdown. As long as the index doesn’t surpass the strike price by the option’s expiration, the covered call strategy can still capture some of the recovery’s upside. Moreover, the premium collected from selling the call option can enhance overall returns during this period, offering a buffer against volatility while still participating in a portion of the market’s rebound.

Looking at the biggest drawdowns over the past 20 years, a covered call strategy (as represented by the S&P/ASX BuyWrite Index) has recovered in a quicker timeframe to the broader market most of the time. During the Global Financial Crisis (GFC), a covered call strategy fell by up to a third less than the broader market, and recovered almost 3 years quicker. While the broader market did recover quicker during 2018 US-Chinese trade war and COVID-19, it was only by a matter of months.

Myth 2: Income from covered call ETFs is not tax-efficient

Given the income component from a covered call strategy contributes the bulk of the total returns, many investors may think this will create more tax consequences. This is because the Australian Taxation Office (ATO) classifies the premium income from an option as a capital asset that could incur capital gains tax (CGT) and may not be eligible for the 50% CGT discount. However, in the event the call option is exercised, the premium is not considered a CGT event and instead becomes part of the cost base when disposing of the underlying assets.6

Some may think that because these are treated as “capital” rather than “dividends”, and likely sit in the “Other Sourced Income” component, there are no extra tax benefits. However, there may be both franking credits and foreign income tax offsets available to investors depending on their circumstances.

Australian equity-covered call ETF investors may be eligible to receive franking credits if certain rules are satisfied. To be eligible for franking credits, shares must be held ‘at risk’ for 45 days.7 To meet the ‘at risk’ criteria, shares must be held for a minimum of 30% of the day, indicating that the options strategy should maintain a net delta of +0.3. An option’s Delta represents the sensitivity of the option to change in the price of the underlying asset. The net delta is the sum of the long index’s delta (+1) and the delta of the short call option (negative variable delta). Days with a net delta above +0.3 contribute to the ‘at risk’ period, while days below +0.3 do not. At the beginning of each quarter, the net delta of an at-the-money covered call strategy is likely to start at +0.5, ensuring the shares are considered ‘at risk.’ The net delta decreases with a rise in the index value (and vice versa).

For US-based covered call strategies, a 15% withholding tax may apply to income sourced from the US (including both options and dividend income). However, Australian investors may benefit from the foreign income tax offsets available depending on the year-end component classification, which is designed to reduce the overall income tax liability for Australian residents on foreign income, including income subject to US withholding tax.

Myth 3: Covered Calls Are Not Good Long-Term Investments

It’s widely understood that markets tend to grow over the long term, but the source of returns – whether from capital gains or dividends – can vary depending on market conditions and investor behaviour. This is particularly relevant for the Australian market where most of the share market returns have come from dividends as opposed to capital gains. Once you stripped out dividends, since its inception the S&P/ASX 200 Index has only appreciated 4.9% p.a. in price, and that’s before including inflation. Considering the Australian share market has historically returned ~10% p.a. that means over half of the total returns are attributable to dividends.8

This is quite different to other markets like the US, where capital gains have driven the majority of the total share market returns. When a share market’s success has been attributed mainly to the sources of income rather than its underlying price growth, that could present an attractive backdrop for covered call strategies, given their outperformance in side-ways and down markets. In Australia, this seems to historically be the case, as over the past 20 years, a covered call strategy has outperformed the broader share market.

Over rolling 5-year periods, an Australian covered call strategy has outperformed the broader market approximately 60% of the time. However, performance comparisons also depend on the level of risk involved – that is, the quality of returns. Covered call ETFs as represented by the S&P/ASX BuyWrite Index, have delivered similar returns with lower risk, resulting in superior risk-adjusted returns and a smoother return profile.

Conclusion

Covered call strategies have long been a part of the investment landscape, yet many Australian investors are just beginning to explore how to integrate them effectively into their portfolios. Designed for income-focused investors, covered calls offer the potential to enhance income streams while also delivering historically strong risk-adjusted returns. Additionally, the research above suggests they tend to recover well following market downturns and can also come with some tax benefits. For investors looking to boost their income potential without compromising on portfolio stability, covered calls can offer a compelling value proposition.

Related funds

Global X S&P/ASX 200 Covered Call ETF (ASX: AYLD) writes call options on the S&P/ASX 200 Index, saving investors the time and potential expense of doing so individually.

ETF

Global X S&P/ASX 200 Covered Call ETF (AYLD)

Australian Shares

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Global X Nasdaq 100 Covered Call ETF (ASX: QYLD) writes call options on the Nasdaq 100 Index, saving investors the time and potential expense of doing so individually.

ETF

Global X Nasdaq 100 Covered Call ETF (QYLD)

Global Shares

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Global X S&P 500 Covered Call ETF (ASX: UYLD) writes call options on the S&P 500 Index, saving investors the time and potential expense of doing so individually.

ETF

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

Global Shares

View

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