What is a Covered Call ETF?

Understanding The Role of Options in Covered Call ETFs

Options are pivotal in generating additional income from the underlying portfolio of stocks in Covered Call ETFs. The issuer of the ETF, such as Roundhill Investments, sells call options on the stocks to generate a stream of income. These are collected from investors who buy call options that give them the right to purchase the underlying stocks at a predetermined price within a particular time duration. While this provides additional income, it does cap the potential for capital appreciation over time.

This is a key feature of Covered Call ETFs that we believe makes them attractive to investors looking to attempt to maximize their income while protecting against market volatility. They may be less relevant to investors looking to make gains in a strongly rising market who are less concerned about immediate income and volatility.

 

Covered Call ETF Distributions and Income Potential

Covered Call ETFs are designed to generate income for investors through the premiums collected from selling call options on the underlying assets in the portfolio. Typically, these premiums will be distributed to investors in the ETF as income, usually on a quarterly or monthly basis. These income distributions can provide a steady source of income, making them an attractive option when interest rates are low and where traditional vehicles such as savings accounts or bonds offer lower yields.

The amount of income generated will depend on factors such as the performance of the ETF portfolio and the option premiums received. While selling options provide additional income, it does cap the potential for capital appreciation. If the value of the underlying stocks rises significantly above the strike price, they may have to be sold at that price. This limits the amount of potential upside gains. The ETF balances the pursuit of income with a more moderate approach to growth.

 

What are 0DTE Options?

0DTE options stand for “Zero Days to Expiration”. These are contracts that have extremely short expiration periods, usually of a single day. They are used by traders and ETF providers to take advantage of short-term price movements or to manage rapid fluctuations in overall market conditions.

Here’s how they work:

 

0DTE Options: The Basic Mechanics

0DTE options have an extremely short lifespan and are used by traders and ETF providers looking to quickly capitalize on short-term price fluctuation in underlying assets. They are susceptible to price changes and volatility, with traders using 0DTE options to speculate on price movements or hedge positions within a brief time frame. Traders and ETF providers need to be skilled at successfully navigating swift fluctuations in the market if they are to capitalize on volatility.

 

How do 0DTE Covered Call ETF's work?

Covered Call ETFs allow ordinary investors to access the dynamic 0DTE trading environment. They combine a traditional portfolio of stocks with an 0DTE options strategy on these holdings. As with a typical equity ETF, the fund holds a diversified selection of stocks. However, the key difference is that the fund manager can sell 0DTE call options on some or all of these stocks to acquire premium income.

 

The role of 0DTE options in Covered Call ETFs

Call options play a crucial role in generating income in a covered call ETF. As 0DTE call options expire on the same day they are written, the ETF can capture the premium income quickly. This short time frame accelerates the time decay, with options rapidly losing value over the trading day. The ETF can collect the premium as immediate income while limiting the duration of risk exposure.

The portfolio needs to be carefully managed, with strike prices selected that balance the potential income with the underlying risk. This is essential because if a stock’s price rises above the strike price during the trading day, the ETF may then have to sell the stock at that price, limiting the potential for further gains.

0DTE options in this strategy are used to provide a consistent income stream for investors.

 

Covered call ETFs and dividend ETFs: Understanding the differences

Income-focused investors have several options to achieve their financial goals. Covered Call ETFs and dividend ETFs both generate and deliver income to investors, but they differ in how this is achieved. Both have advantages and disadvantages, and each may be more suitable for some investors.

Dividend ETFs (sometimes called traditional ETFs) are made up of a portfolio of stocks that regularly pay dividends. These dividends paid by the underlying companies provide income to investors in the ETF. The generated income is linked to the company's performance rather than market volatility. These tend to be suitable for investors looking for a reliable ongoing income. A dividend ETF has the potential for capital growth as the underlying companies grow over time, leading to dividend increases. There is no cap on the upside potential of the holdings in the ETF portfolio.

Covered Call ETFs primarily generate income by selling call options on the stocks in the portfolio. The premiums collected from option sales provide regular income to investors. If the value of stocks in the portfolio rises above the option strike prices, they may have to be sold, thus limiting the potential for further capital appreciation. Covered Call ETFs may suit investors looking for a potentially more lucrative income stream with less concern for longer-term capital growth.

 

Types of Covered Call ETFs

Covered Call ETFs generally have a broad market or sector-specific focus:

 

Broad Market Summary

Broad market Covered Call ETFs typically hold a diversified portfolio of large-cap stocks that broadly mirror the composition of a major market index, such as the S&P 500. Call options on these stocks are sold to generate income for investors. Because they have broad market coverage, they offer diversification across various sectors, reducing the risk associated with individual stock performance. Because of its breadth, it may fare less well compared to ETFs with portfolios focused on a sector performing beyond the market average.

 

Broad Market Covered Call ETFs from Roundhill Investments

We offer three actively managed Covered Call ETFs with broad market exposure:

• The Roundhill S&P 500® 0DTE Covered Call Strategy ETF (XDTE) is the first ETF to utilize zero days to expiry options on the S&P 500. This actively managed ETF provides overnight exposure to the S&P 500 and seeks to generate income each morning by selling out the 0DTE calls on the index.

 

• The Roundhill Innovation-100 0DTE Covered Call Strategy ETF (QDTE) is the first ETF to utilize zero-days-to-expiry (“0DTE”) options on an innovation index. This actively managed ETF provides overnight exposure to the Innovation-100 Index and seeks to generate income each morning by selling out the 0DTE calls on the Index.

 

• The Roundhill Small Cap 0DTE Covered Call Strategy ETF (RDTE) is the first ETF to utilize zero days to expiry options on the Russell 2000® Index. This actively managed ETF provides daily exposure to the Russell 2000® Index and seeks to generate income each morning by selling out-of-the-money 0DTE call options on the Index.

 

Sector Specific

The investments within a sector-specific covered call ETF portfolio are concentrated within a particular industry or sector, such as technology, energy, or healthcare. As with a broad market ETF, call options are sold on the holdings to generate income. The concentrated nature of sector-specific ETFs means they can be more susceptible to volatility within the sector they represent. However, they also offer the potential for higher income, with stocks in higher volatility sectors often commanding higher option premiums.

 

Should You Buy A Covered Call ETF?

Over recent years, Covered Call ETFs have become popular among investors primarily focusing on income. Offering an income-driven strategy while seeking to reduce risk, they offer a proactive approach to income generation. However, as with any investment, a Covered Call ETF is not for everyone. All investments carry some risks, and weighing the benefits against the potential drawbacks is important before deciding if it’s the right investment for your portfolio.

 

What are the benefits of investing in covered call ETFs?

If you’re looking for a more pragmatic approach to stock market investing but are seeking a regular income, then Covered Call ETFs do offer several advantages:

• Enhanced income: covered call ETFs have the potential to provide an enhanced income for investors. The ETF collects premiums from the buyers of call options on the underlying stocks. These premiums can then be distributed as income to investors on a weekly, monthly, or quarterly basis. This can make it a very attractive option in low-interest rate environments or for people looking for additional income.
• Lower volatility compared to individual stocks: covered Call ETFs will usually have lower volatility when compared to individual stocks. The regular income that options can provide helps to smooth out returns from a diversified underlying portfolio of stocks and reduces the impact of sharp movements in the market. Combining stock diversification with an income-generating covered call strategy can provide a less volatile investment for investors prioritizing income.

 

What are the Risks and Considerations for Investing in Covered Call ETFs?

As with any investment, there are risks associated with Covered Call ETFs. What risks and other potential downsides should investors consider?

• Market risk: market risk is a built-in feature of any equity-based investment, and covered call ETFs are no exception. In practice, this means that should the overall stock market decline, the value of stocks within the ETF portfolio will also reduce. While premiums generated by selling call options do offer some potential protection against market volatility, they cannot usually offset significant market losses entirely.
• Options-related risk: it’s important to remember that upside gains are effectively capped in a covered call ETF. When a covered call is written, the sale of the underlying stock is agreed to at a predetermined strike price when the option is exercised. Should the stock’s price rise above the strike price, the ETF still has to sell the stock at the agreed lower price. This means that potential gains can be lost, with the potential for underperformance in bullish markets. The overall effectiveness of the covered call strategy is influenced by overall market volatility, with low-volatility environments delivering lower option premiums. This reduces the income generated by the ETF.
• Distribution Tax Risk: Distributions may exceed the Fund’s income and gains for the Fund’s taxable year. Distributions in excess of the Fund’s current and accumulated earnings and profits will be treated as a return of capital. A return of capital distribution generally will not be taxable but will reduce the shareholder’s cost basis and will result in a higher capital gain or lower capital loss when those Fund Shares on which the distribution was received are sold. Once a Fund shareholder’s cost basis is reduced to zero, further distributions will be treated as capital gain if the Fund shareholder holds Fund Shares as capital assets. Additionally, any capital returned through distributions will be distributed after payment of Fund fees and expenses. Because a portion of the Fund’s distributions may consist of return of capital, the Fund may not be an appropriate investment for investors who do not want their principal investment in the Fund to decrease over time or who do not wish to receive return of capital in a given period. In the event that a shareholder purchases Fund Shares shortly before a distribution by the Fund, the entire distribution may be taxable to the shareholder even though a portion of the distribution effectively represents a return of the purchase price.

Another consideration is the risk of early option exercise, which can occur if the option buyer chooses to exercise their right before expiration. This could potentially force the ETF to sell the stock at an inopportune time.

 

What are the differences between covered call income and dividends?

Covered call income and dividends are both sources of income that investors can receive on their investments, but they have important differences.

Covered call income is generated when call options on a stock or portfolio of stocks are sold. When an ETF writes a covered call, a premium is received from the buyer of the option. This premium income is then distributed to investors in the ETF in the form of income, usually on a weekly, monthly, or quarterly basis. The amount of income this strategy generates depends on market conditions and the volatility of the underlying stock within the portfolio. Covered call income can be substantial, but it is also capped, with the ETF manager having to sell underlying stock if it rises about the option’s strike price.

Companies pay dividend income to their shareholders from their profits. These can be more stable and predictable than covered call income, with many companies having well-established dividend policies. The size of dividends reflects the health of the company and its market value. They provide a consistent payout to shareholders, usually every quarter. Dividends are not linked to market volatility and involve selling options. This means that the underlying investment remains until the investor or fund manager chooses to make a sale.

While dividends give investors some degree of predictability, covered call income can offer a higher income at the expense of capping the growth potential of the underlying asset.

 

Factors Influencing Performance

One of the primary factors impacting Covered Calls ETFs' performance is overall market conditions. In periods of higher volatility, option premiums are more likely to increase. This means that the income generated from selling call options can grow. However, higher volatility also increases the likelihood that the underlying stocks may need to be sold if the prices rise sharply. This can cap the ETF’s upside potential. In lower volatility markets, the risk of stocks being called away decreases. This also means that the collected premiums are likely to be lower, but the risk of stocks being called away also decreases.

The underlying stock prices are another key factor in the performance of a Covered Call ETF. If the ETF portfolio grows strongly, the gains can be limited by the strike prices of the sold call options. This may result in underperformance compared to a traditional equity ETF that isn’t compelled to sell the stock and can benefit fully from any price appreciation.

The overall performance of the underlying investments within the ETF portfolio will impact the size of any premiums paid.

 

The Tax Implications of Covered Call ETFs

Covered Call ETFs can provide an attractive income stream, but it’s essential to understand the tax implications. The tax treatment of distributions and premiums can significantly impact your after-tax returns.

 

Tax treatment of distributions and premiums

Dividends paid by the stocks in the ETF will typically be taxed at the qualified dividend rate if they meet specific IRS requirements. This rate is generally lower than the ordinary income tax rate. Qualified dividends are currently taxed at the preferential rates of 0%, 15%, or 20% based on income.

Premiums received from the sale of call options on investments in an ETF portfolio are usually considered short-term capital gains for taxation purposes. These are taxed at the ordinary income tax rate paid by the investor, regardless of how long the underlying stock is held. This can mean that premiums carry a higher tax liability compared to qualified dividends. If the ETF provider is required to sell underlying stocks when options are exercised, any gains may also be subject to capital gains tax, depending on the holding period.

 

Future Trends in Covered Call ETFs

During periods of low interest rates and increased market volatility, investors continue to seek income-generating strategies. This means covered ETFs are poised for continued growth, and innovation is also shaping the future landscape of the investment category.

 

Growth in popularity

ETFs have grown in popularity significantly over recent years. As investors look for ways to generate income in a low-yield environment.

This growth is driven by income-focused investors. Increasing market volatility has enhanced the appeal of Covered Call ETFs, which can reduce portfolio risk while offering the potential for steady income.

 

Innovation in the covered call ETF market

New product offerings in the covered call ETF market are also driving investor growth. Sector-specific Covered Call ETFs incorporating more advanced options strategies and those designed to perform in various market conditions are expanding the appeal and reach of ETFs to a broader range of investors.

The Roundhill Investments Small Cap 0DTE Covered Call Strategy ETF (RDTE) uses a synthetic covered call strategy to provide current income on a weekly basis while offering exposure to the price return of the Russell 2000 Index, which focuses on small-cap companies. Synthetic exposure increases the likelihood that the ETF’s returns may not always precisely align with the returns of the corresponding index.

Unlike traditional covered call strategies that sell options on securities that are already owned, the RDTE ETF purchases in-the-money call options on the index. This creates prolonged exposure to the index’s price returns while simultaneously selling out-of-the-money 0DTE call options on the same index.

Emerging trends and innovation will likely increase the overall appeal of covered call ETFs to a wide range of income-focused investors.

 

Covered Call ETFs from Roundhill Investments: Balancing Income and Risk with Innovation

A Covered Call ETF is an attractive option for investors looking to generate consistent income while managing volatility. A covered call strategy can provide regular income distributions by selling call options while mitigating risk in a volatile market. While upsides may be limited in bullish markets, covered call strategies offer investors the potential for a steady income with effective risk management.

Roundhill Investment Covered Call ETFs leverage experience and innovation to make them a strong choice for income-focused investors.

 

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Investors should consider the investment objectives, risks, charges, and expenses carefully before investing. For a prospectus or summary prospectus, if available, with this and other information about the Fund, please call 1-855-561-5728 or visit our website https://www.roundhillinvestments.com/etf/. Read the prospectus or summary prospectus carefully before investing.

All investing involves risk, including the risk of loss of principal. There is no guarantee the investment strategy will be successful. For a detailed list of fund risks see the prospectus.

Ether Futures ETF Risks. The Ether Futures ETFs do not invest directly in ether. Accordingly, the performance of an Ether Futures ETF should not be expected to match the performance of ether. The Fund will have significant exposure to an Ether Futures ETF through its options positions that utilize an Ether Futures ETF as the reference asset.

Ether Risk. Ether is a relatively new innovation and the market for ether is subject to rapid price swings, changes and uncertainty. The further development of the Ethereum network and the acceptance and use of ether are subject to a variety of factors that are difficult to evaluate. The slowing, stopping or reversing of the development of the Ethereum network or the acceptance of ether may adversely affect the price of ether. Ether is subject to the risk of fraud, theft, manipulation or security failures, operational or other problems that impact the digital asset trading venues on which ether trades. The Ethereum blockchain, including the smart contracts running on the Ethereum blockchain, may contain flaws that can be exploited by hackers. A significant portion of ether is held by a small number of holders sometimes referred to as “whales.” Transactions of these holders may manipulate the price of ether.

Unlike the exchanges for more traditional assets, such as equity securities and futures contracts, ether and the digital asset trading venues on which it trades are largely unregulated or may be operating out of compliance with applicable regulation. As a result, individuals or groups may engage in fraud or market manipulation (including using social media to promote ether in a way that artificially increases the price of ether). Investors may be more exposed to the risk of theft, fraud and market manipulation than when investing in more traditional asset classes.

Ether Futures Risk. The market for ether futures contracts may be less developed, and potentially less liquid and more volatile, than more established futures markets. W

Futures Contract Risk. Risks of futures contracts include: (i) an imperfect correlation between the value of the futures contract and the underlying asset; (ii) possible lack of a liquid secondary market; (iii) the inability to close a futures contract when desired; (iv) losses caused by unanticipated market movements, which may be unlimited; (v) an obligation for an Ether Futures ETF to make daily cash payments to maintain its required margin, particularly at times when an Ether Futures ETF may have insufficient cash; and (vi) unfavorable execution prices from rapid selling. Unlike equities, which typically entitle the holder to a continuing stake in a corporation, futures contracts normally specify a certain date for settlement in cash based on the reference asset.

Covered Call Strategy Risk. A covered call strategy involves writing (selling) covered call options in return for the receipt of premiums. The seller of the option gives up the opportunity to benefit from price increases in the underlying instrument above the exercise price of the options, but continues to bear the risk of underlying instrument price declines. The premiums received from the options may not be sufficient to offset any losses sustained from underlying instrument price declines, over time. As a result, the risks associated with writing covered call options may be similar to the risks associated with writing put options. Exchanges may suspend the trading of options during periods of abnormal market volatility. Suspension of trading may mean that an option seller is unable to sell options at a time that may be desirable or advantageous to do.

Flex Options Risk. Trading FLEX Options involves risks different from, or possibly greater than, the risks associated with investing directly in securities. The Fund may experience losses from specific FLEX Option positions and certain FLEX Option positions may expire worthless. The FLEX Options are listed on an exchange; however, no one can guarantee that a liquid secondary trading market will exist for the FLEX Options. In the event that trading in the FLEX Options is limited or absent, the value of the Fund’s FLEX Options may decrease. In a less liquid market for the FLEX Options, liquidating the FLEX Options may require the payment of a premium (for written FLEX Options) or acceptance of a discounted price (for purchased FLEX Options) and may take longer to complete. A less liquid trading market may adversely impact the value of the FLEX Options and Fund shares and result in the Fund being unable to achieve its investment objective. Less liquidity in the trading of the Fund’s FLEX Options could have an impact on the prices paid or received by the Fund for the FLEX Options in connection with creations and redemptions of the Fund’s shares. Depending on the nature of this impact to pricing, the Fund may be forced to pay more for redemptions (or receive less for creations) than the price at which it currently values the FLEX Options. Such overpayment or under collection could reduce the Fund’s ability to achieve its investment objective. Additionally, in a less liquid market for the FLEX Options, the liquidation of a large number of options may more significantly impact the price. A less liquid trading market may adversely impact the value of the FLEX Options and the value of your investment. The trading in FLEX Options may be less deep and liquid than the market for certain other exchange-traded options, non-customized options or other securities.

Counterparty Risk. Fund transactions involving a counterparty are subject to the risk that the counterparty will not fulfill its obligation to the Fund. Counterparty risk may arise because of the counterparty’s financial condition (i.e., financial difficulties, bankruptcy, or insolvency), market activities and developments, or other reasons, whether foreseen or not. A counterparty’s inability to fulfill its obligation may result in significant financial loss to the Fund. The Fund may be unable to recover its investment from the counterparty or may obtain a limited recovery, and/or recovery may be delayed.

New Fund Risk. The fund is new and has a limited operating history.

Concentration Risk. The Fund may be susceptible to an increased risk of loss, including losses due to adverse events that affect the Fund’s investments more than the market as a whole, to the extent that the Fund’s investments are concentrated in investments that provide exposure to ether. 

Non-Diversification Risk. As a “non-diversified” fund, the Fund may hold a smaller number of portfolio securities than many other funds. To the extent the Fund invests in a relatively small number of issuers, a decline in the market value of a particular security held by the Fund may affect its value more than if it invested in a larger number of issuers. The value of the Fund Shares may be more volatile than the values of shares of more diversified funds.

Roundhill Financial Inc. serves as the investment advisor. The Funds are distributed by Foreside Fund Services, LLC which is not affiliated with Roundhill Financial Inc., U.S. Bank, or any of their affiliates.

0DTE Options Risk.*** The Fund’s use of zero days to expiration, known as “0DTE” options, presents additional risks. Due to the short time until their expiration, 0DTE options are more sensitive to sudden price movements and market volatility than options with more time until expiration. Because of this, the timing of trades utilizing 0DTE options becomes more critical. Although the Fund intends to enter into 0DTE options trades on market open, or shortly thereafter, even a slight delay in the execution of these trades can significantly impact the outcome of the trade. Such options may also suffer from low liquidity, making it more difficult for the Fund to enter into its positions each morning at desired prices. The bid-ask spreads on 0DTE options can be wider than with traditional options, increasing the Fund’s transaction costs and negatively affecting its returns. Additionally, the proliferation of 0DTE options is relatively new and may therefore be subject to rule changes and operational frictions. To the extent that the OCC enacts new rules relating to 0DTE options that make it impractical or impossible for the Fund to utilize 0DTE options to effectuate its investment strategy, it may instead utilize options with the shortest remaining maturity available or it may utilize swap agreements to provide the desired exposure.

 

Glossary

Options: An option is a contract sold by one party to another that gives the buyer the right, but not the obligation, to buy (call) or sell (put) a stock at an agreed upon price within a certain period or on a specific date.

Covered Call Strategy: A covered call strategy involves writing (selling) covered call options in return for the receipt of premiums. The seller of the option gives up the opportunity to benefit from price increases in the underlying instrument above the exercise price of the options, but continues to bear the risk of underlying instrument price declines.

Out-of-the-Money Options: Out-of-the-money options are options whose strike price is above the market price of the underlying asset.

Notional Exposure: The total value controlled by the Fund’s portfolio of option contracts. Notional exposure is calculated by multiplying the number of contracts held by the underlying index price and multiplying this product by the contract multiplier of $100. 

Strike: The price at which an owner of a call (put) option has the right, but not the obligation, to purchase (sell) a stock for at the time of the option’s expiration.

Upside: Reflects the degree of upside potential that could be experienced by a reference asset, expressed as a percentage, before it moves above the strike price of an associated short call option. The likelihood that the short call option will be exercised effectively creates a cap on potential gains.

Expiration Date: The last date that an option contract is valid before it expires and ceases to exist.

Days to Expiry: The number of calendar days until an option contract’s expiration date.

Small Cap Index: The Small Cap Index is a measure of the performance of the small-capitalization sector of the U.S. equity market, as defined by FTSE Russell. The Small Cap Index is a subset of the Russell 3000® Index (the “Broad Market Index”), which measures the performance of the broad U.S. equity market, as defined by FTSE Russell. The Small Cap Index is a float-adjusted capitalization-weighted index of equity securities issued by the smallest issuers in the Broad Market Index. 

Innovation-100 Index: The Innovation-100 Index is a globally recognized index that tracks the performance of 100 of the largest non-financial companies listed on the Nasdaq Stock Market®, encompassing a diverse range of industries and sectors. The components of the Innovation-100 Index are weighted pursuant to their market capitalization. The index is rebalanced quarterly and reconstituted annually.