The Mechanics and Limits of Covered-Call Income
Distribution rates over 10% a year, money landing every month. The advertising for covered-call income products is attractive. But there is no free income in the world, and the price is "losing out in a rising market."
How a Covered Call Works
A covered call is a strategy of selling a call option on a stock while holding that stock.
When you sell a call option, you immediately receive a premium (the option price) in return. This premium is the source of the high "distribution" of a covered-call product. In exchange, if the share price rises sharply, you must hand over that gain to the option buyer because of the call option you sold. In other words, you sell "future upside potential" in exchange for receiving "income now."
Price 1: The Upside Is Cut Off
The biggest limit of a covered call is that the upside is capped in a rising market. When the market rises sharply, you cannot fully enjoy the gain because of the call option you sold.
Looking at actual data, JEPI, a covered-call ETF on the S&P 500, returned only about 10.5% on a price basis over a certain comparison period, while SPY, which tracks the S&P 500 over the same period, rose about 20.1%. It stayed at roughly half the performance in the rising market. That is the result of giving up much of the growth in exchange for income.
A high distribution rate is different from total return. If you give up the upside in a rising market, you can lag the market in total return even while receiving large dividends.
Price 2: The NAV Can Erode
What you should watch even more is net asset value (NAV) erosion. If a product distributes more than it earns, that excess is effectively a return of your own principal (return of capital), and the NAV shrinks.
For example, QYLD, a covered-call ETF on the Nasdaq 100, saw its NAV fall about 9.3% over three years while distributing a high 11-12% annually. Part of the distribution was a return of capital. Conversely, over the same period JEPI's NAV actually rose, showing that its distributions came from genuine profit. Because results differ greatly by product, you must always check the NAV trend and total return, not just the distribution rate.
よくある質問
Q. Are covered-call products safe in a falling market?
They cushion, but they are not a shield. They offset the decline a little by the amount of the call-option premium, but that premium is usually small compared with the size of the price drop. In a large downturn, covered-call products can also fall sharply along with the market.
Q. Isn't a high distribution rate a sign of a good product?
A high distribution rate does not mean a high total return. If part of the distribution is a return of capital, the NAV erodes and you are effectively getting your own money back. Rather than the distribution rate, you should look at the NAV trend and total return (price + distributions) to know the real performance.
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