Overview
In the last couple years, plenty of single stock covered call ETFs have hit the market. Most funds have targeted underlying exposures with substantial implied volatility levels, and while the premiums look enticing, a large number of these ETFs have underperformed the underlying stock return.
In this blog, we will:
- Help you understand that covered call strategies are not a bullish investment vehicle
- Identify why underperformance is occurring
- Explore other derivative methods which may be better suited for investors looking to get bullish exposure to a single stock while maintaining consistent cashflow generation
In order to do so, we’ll need to back up into a brief 101 on leverage and delta.
Can I have more for less?
Say an investor wants to create a long position in a stock. One way to do so would be to purchase the stock for cash. It would cost 100% of the price of the equity. However, what if the investor didn’t have to spend 100% to get the same exposure? That is leverage. Leverage, in the context of capital markets, allows traders to create larger position sizes using a smaller amount of capital.
Options are one form of leverage. An investor could purchase a call option and sell a put option with the same strike, spending much less money to acquire the same exposure as purchasing “physical” stock. Looking at it another way, that investor could spend 100% of their capital purchasing many, many contracts of this call-put combo (generally known as a bullish/long forward), and create a substantially larger exposure to the underlying stock than buying shares for cash.
Swaps are another avenue to acquire leverage. They are not as well known to the retail community as they trade over-the-counter (OTC), unlike options which generally trade in listed markets. A swap is an OTC product in which the buyer pays a bank to purchase or short a security for a given period of time, and, in exchange, the performance of that security is swapped at the end of the trade’s tenor. For example, if an investor bought the S&P 500 Index on swap, and the S&P 500 Index rallied 5% during the tenor of the trade, the bank/counterparty would then pay that investor 5% at expiry. If the investor instead went short S&P 500 Index on swap, then the investor would owe the bank 5% at expiry. What does a swap cost? It depends on the cost of the bank to hold the exposure on their balance sheet and how difficult it is to borrow/lend that security.
What is delta?
Delta is one of the option greeks. It measures an option’s sensitivity to the underlying asset price. For example, if an investor owns a call option on XYZ with a +50% delta, for every $1 increase in XYZ, they can expect a $0.50 increase in the price of their option.
Delta, like all other option greeks, is directional.
- Purchasing a call option and selling a put option (also known as a synthetic long when combined) are both long/positive delta.
- Conversely, selling a call option and buying a put option (a synthetic short when combined) are both short/negative delta.
If the investor instead sold the call option on XYZ, their option price would decrease $0.50 for every $1 increase in the underlying stock price.
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Put (Bearish) |
Call (Bullish) |
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Short (Bearish) |
Positive Delta |
Negative Delta |
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Long (Bullish) |
Negative Delta |
Positive Delta |
In essence, delta tells us how much our position's value will move for a $1 move in the underlying stock. If I own a stock and then sell an out-of-the-money call option on it, my stock delta is +100% and the short call option delta is negative, let’s call it -30%. The combination of these two positions creates a total delta exposure of +70% at inception of the trade.
It’s important to note that deltas are not stagnant – they will move as the underlying stock price moves around the option strike. That relationship of delta to stock price is depicted below in the delta curve. As an option gets further out-of-the-money, its delta gets smaller in magnitude until it reaches 0. As an option gets further in-the-money, its delta grows to +/-100%. An at-the-money option will have a 50% delta.
Source: Roundhill Investments, for illustrative purposes only
Why is all this information important? Lets take a look at the economics of a covered call strategy.
What do you mean “capped upside”?
As mentioned earlier, a short call is a short delta position and that delta will change as the underlying stock moves around the strike. A long stock position will always be 100% delta, as its performance is identical to the price movements of the stock. Therefore, in a covered call position, as the stock moves toward the strike (appreciates in price), the short delta will grow and the total position delta (option + cash stock) will shrink. When the option is sufficiently in-the-money and trading at a -100% delta, the long cash position and short option positions deltas will be offset, and the upside will be capped. This payoff is depicted below.
As you can see, the Net Exposure line (option + stock) has little-to-no sensitivity to the underlying asset as the stock moves higher.
Source: Roundhill Investments, for illustrative purposes only
If upside is capped, why are covered call positions so popular on sentimentality bullish stocks like Nvidia (NVDA) and Tesla (TSLA)? Because on an initial look the volatility looks very attractive. Selling a 1-month 105% strike TSLA call yields 3.8% in premium. On an annualized basis that equates to 45.6%.1 However, that volatility is only beneficial if the realized volatility of the stock is lower than the option’s implied volatility and the stock remains below call strike. If the stock outperforms volatility market expectations (realized vol > implied vol) due to the stock trading higher than expected, the investor loses money by capping their upside as opposed to holding the cash stock outright. This phenomenon is depicted below by looking at implied vs realized volatility levels on TSLA.
This rationale tends to be why covered call strategies on indices and ETFs, which operate at a lower level of volatility, tend to have more stable total return profiles.
A bullish view AND cash generation
Is it possible to express a bullish view while providing consistent cash payments to investors without reducing sensitivity to moves higher in the underlying stock? Enter the Roundhill WeeklyPay™ suite.
As we discussed earlier, there are other methods of generating leverage. As opposed to utilizing options, the WeeklyPay™ suite employs swaps to synthetically create 1.2X weekly leverage to the single stock within each ETF. You can think of 1.2X leverage as being similar to owning a +120% delta position: for each $1 increase in the stock price, your position will increase by $1.20. That is a bullish delta. The payoff of this leverage is denoted in the graphic below.
Source: Roundhill Investments, for illustrative purposes only
How does this ETF distribute cash? Roundhill has designed a set of parameters based on both implied volatility and weekly stock performance to determine ETF distributions, which will be distributed to ETF holders on a weekly basis.
In conclusion…
Both covered call and levered weekly distribution strategies can generate favorable returns, but they generate favorable returns in different market environments. Covered call strategies tend to outperform the benchmark in down-to-neutral market conditions, and they underperform in up markets. Whereas, a levered weekly distribution strategy will outperform the benchmark in up markets and underperform in down-to-neutral markets. Investors should be aware of and consider the payoff profile of each strategy when making their investment decisions.
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Sources:
1 Bloomberg as of 2/5/2025
Glossary:
The S&P 500 Index or Standard & Poor's 500 Index is a market-capitalization-weighted index of 500 leading publicly traded companies in the U.S.
A Call option is financial contract that gives the buyer the right to buy a specified amount of an underlying security at a predetermined price within a specified time frame
A put option is a financial contract that gives the buyer the right to sell a specified amount of an underlying security at a predetermined price within a specified time frame
