ETFs with embedded options selling strategies have proliferated over the past few years, with several new funds coming onto the market attempting to generate high income by using covered call strategies. As technology stocks tend to have higher levels of implied volatility compared to the S&P500, the strategies that buy the Nasdaq 100 and sell offsetting call options have been able to offer exceptionally high yields. In this article I will take a look at the strengths and weaknesses of the main Nasdaq enhanced income ETFs on the market, before offering a note of caution about their efficacy in current market conditions.
Comparing The 3 Main Enhanced Income ETFs
There is not much between the three main Nasdaq 100 enhanced income ETF. They all sacrifice upside in exchange for option income while maintaining downside risk, but some subtle differences could impact their performance under different market conditions.
High yield but expensive and no upside exposure /high daily downside exposure
QYLD JEPQ QQQY Strategy Sells monthly ATM calls Sells monthly 2.5% OTM calls Sells daily ATM puts Yield 11.5 9.7 20.5 Expense Ratio 0.60 0.35 0.99 Volatility 7.9 8.8 13.3 Returns since September 14 5.8 9.4 8.1 Summary High yield and low volatility but sacrifices capital gains Relatively cheap and offers some upside exposure
High yield but expensive and no upside exposure /high daily downside exposure
The Global X NASDAQ 100 Covered Call ETF (QYLD) was launched at the end of 2013 but assets under management only begun to rise significantly over the past few years. Its returns have lagged significantly since inceptions, generating 7.6% annual returns, 10pp less than the Nasdaq 100. The QYLD's underperformance reflects its strategy of selling monthly options that are at the money or as close as possible, which means that it barely participated in any upside in the Nasdaq 100. Almost all its returns are generated by the options premiums.
The JPMorgan Nasdaq Equity Premium Income ETF (JEPQ) has been around since May 2022 and its assets under management have ballooned since then, allowing it to overtake the QYLD. The JEPQ has outperformed the QYLD since its inception due to its strategy of writing monthly 30-delta out-of-the-money calls, whose strike prices fluctuated around a historical average of 2.5% above the index price. This enables the ETF to participate in some upside in the event of Nasdaq rallies at the expense of slightly lower option income, which explains why its dividend yield is lower.
Finally, the Defiance Nasdaq 100 Enhanced Options Income ETF (QQQY), which came onto the market in September last year, does not sell calls but sells puts. It does not hold the Nasdaq 100 itself, but holds Treasuries, and sells daily options to realize rapid time decay by selling in the money puts with 0DTE (zero days to expiry). This enables the fund to generate higher yields than the QYLD and JEPQ, but like the QYLD the QQQY offers almost zero exposure to capital gains, which explains why it has underperformed the JEPQ in the recent Nasdaq 100 advance. The QQQY also has a higher expense ratio, charging 0.99% compared with 0.6% for the QYLD and 0.35% for the JEPQ.
Current Conditions May Not Be Suitable For Selling Volatility
The high income offered by these ETFs suggests that they will outperform the Nasdaq 100 itself over the coming years as the prospect for significant further capital gains from current valuations seems slim. However, current conditions do not seem conducive to selling volatility on tech stocks. The ideal conditions for this strategy are when implied volatility is high, offering high call option income, and markets trade sideways. During bull markets the strategy tends to underperform relative to long only as call options lose money, acting as a drag on returns. During market crashes, the steady income generated by call sales does little to offset the capital losses on underlying holdings. Currently, implied volatility levels are low, meaning that option income will be limited, while the risks of a large directional move are growing.
On the upside, there is a growing risk that the recent break to new all time highs triggers panic buying of the kind not seen since late-1999, when the Nasdaq 100 doubled in less than 6 months from already extreme valuations to historic bubble valuations. On the downside, there is a growing risk that the Nasdaq suffers a downside reversal as it recouples with bond yields, which imply fair valuations of less than half of current levels. A permanently high plateau, as implied by options markets and Wall Street analysts seem highly unlikely.
There has been a surge in interest in Nasdaq 100 enhanced income strategies in recent years, with QYLD, JEPQ, and QQQY representing the main ETFs. Bulls would be better off in the JEPQ as this offers greater upside potential, while those looking to maximise income would be better off in the QQQY. The current juncture seems like a bad time to own these three income based ETFs, regardless of whether you are bullish or bearish, as implied volatility seems too low relative to the risks of a sharp rise or reversal. Short sellers would be best off selling the QQQY as it offers greater exposure to daily declines due to its high are a result of shorter term option sales.
This article was written by
I am a full-time investor and owner of Icon Economics - a macro research company focussed on providing contrarian investment ideas across FX, Equities, and Fixed Income based on Austrian economic theory. Formerly Head of Financial Markets at Fitch Solutions, I have 15 years of experience investing and analysing Asian and Global markets.
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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As an investor and macro research specialist with a background in analyzing financial markets and investment strategies, particularly in equities and options, I'm well-versed in the complexities of exchange-traded funds (ETFs) and various income-generating strategies. My expertise extends to understanding market dynamics, volatility, and the intricacies of options trading.
The article discusses the proliferation of ETFs incorporating embedded options selling strategies, particularly focusing on Nasdaq 100 enhanced income ETFs. These ETFs aim to generate high income by employing covered call strategies, taking advantage of the relatively higher implied volatility in technology stocks compared to broader market indices like the S&P 500.
Let's break down the key concepts and components mentioned in the article:
Covered Call Strategies: These involve holding a long position in an asset (such as stocks) while simultaneously selling call options on that same asset to generate income from the premiums received.
Implied Volatility: Implied volatility reflects the market's expectation of a stock's future volatility as implied by the prices of its options.
Nasdaq 100: The Nasdaq 100 index comprises the 100 largest non-financial companies listed on the Nasdaq stock exchange, representing a substantial portion of the technology sector.
- QYLD (Global X NASDAQ 100 Covered Call ETF): It sells monthly at-the-money (ATM) calls, sacrificing potential upside for high option income.
- JEPQ (JPMorgan Nasdaq Equity Premium Income ETF): It sells monthly out-of-the-money (OTM) calls, aiming to balance option income with some upside exposure.
- QQQY (Defiance Nasdaq 100 Enhanced Options Income ETF): It sells daily at-the-money (ATM) puts, aiming for higher yields but offering limited exposure to capital gains.
Yield: The income generated by the ETFs from selling options, expressed as a percentage of the ETF's price.
Expense Ratio: The annual fee charged by the ETF provider for managing the fund, expressed as a percentage of the fund's assets.
Volatility: The degree of variation of a trading price series over time, typically measured as the standard deviation of returns.
Market Conditions: The article highlights that current market conditions might not be conducive to selling volatility due to low implied volatility levels and the potential risks of significant market moves.
Risk Considerations: It discusses the risks associated with selling volatility, particularly during bull markets and market crashes, and the impact on ETF performance.
Conclusion: The author suggests that while these ETFs offer income-generating opportunities, the current market environment may not favor their strategies, emphasizing the importance of considering market conditions and risk factors when investing.
The author's extensive experience in financial markets and investment analysis lends credibility to the insights provided in the article, offering valuable perspectives for investors considering these Nasdaq 100 enhanced income ETFs.