How to profit from volatility using premium-income ETFs

Double-digit yields are possible with premium-income ETFs, but there are drawbacks

Kaylie Pferten clarifies.

Over the past 20 years, selling (or "writing") options on a portfolio to generate income has grown in popularity. Following the global financial crisis, the strategy gained popularity during the zero-interest-rate era. During the pandemic, central banks once more lowered interest rates below zero.

When investors write call options on their current shareholdings (also referred to as "covered calls"), they receive a premium. The reasoning is straightforward: if a stock you already own doesn't pay a dividend, you can continue to earn money from it; if it does, you can still receive an additional bonus. But trading options is a complicated business that can be expensive if you don't know how to do it. Therefore, numerous attempts have been made to develop products that make this strategy easier for individual investors to use. Premium-income exchange-traded funds (ETFs) are among them. These funds hold a portfolio of stocks, write options on them, and (usually) distribute the proceeds on a monthly basis.

In the UK, premium-income ETFs have started to gain traction. The Global X Nasdaq 100 Covered Call ETF (LSE: QYLP) has accumulated about 0.5 billion, while the JPMorgan Global Equity Premium Income Active ETF (LSE: JEGP) and JPMorgan Nasdaq Equity Premium Income Active ETF (LSE: JEQP) have assets of over 1 billion and 2 billion, respectively.

Problems with BFIA today. Additionally, there is a rapidly expanding selection of smaller products. According to ETF data provider ETFGI, there are 57 such ETFs available to investors in Europe. At the end of March, assets under management totaled £5.6 billion following year-to-date inflows of almost £1 billion.

Using premium-income ETFs is a different strategy.

The most well-liked premium-income ETFs have trailing yields ranging from 7.7 percent for the JPMorgan US Equity Premium Income Active ETF (LSE: JEIP) to 11.5 percent for QYLP. This represents a completely different approach and is significantly higher than the yield on a standard high-yield ETF.

According to Tom Bailey of HANetf, the ETF platform that issues the YieldMax and Rex covered-call ETFs, "Option-income ETFs generate income through writing call options on stocks they hold as well as the dividend income, which is usually much lower than the options income." Therefore, a premium-income ETF chooses stocks based on their potential to earn high options premiums, whereas a dividend-income fund can only own stocks that satisfy specific yield criteria.

These premium-income ETFs are compelled to invest in larger, more liquid stocks due to the need for liquid options markets; however, these stocks are typically different from those of a typical income fund. Energy, utilities, consumer staples, and other dependable dividend payers are frequently held in high-yield ETFs. In contrast, technology stocks are frequently included in premium-income ETFs, according to Bailey. Due to a lack of dividend yield, investors might have otherwise rejected this level of diversification in their income portfolios.

Income funds should not be substituted with premium-income ETFs.

Premium-income ETFs shouldn't be seen by investors as a straightforward substitute for income funds. Because dividend stocks are typically less volatile than other stocks, the value of your portfolio will also be less volatile. Due to their extreme volatility, tech stocks may increase the fund's income, but doing so will result in greater portfolio swings.

Additionally, premium-income ETFs limit equity upside by selling call options on the underlying asset (if a stock rises significantly, the option buyer will exercise their right to purchase the stock from you). In order to receive immediate income returns, investors are trading off a few percentage points of long-term capital gains each year.

Keep in mind that there is no guarantee of income. The price of options fluctuates and is influenced by a number of variables. In times of market turbulence, premiums and income will increase, while in times of calm, they will decrease. For instance, the trailing yield of the YieldMax Big Tech Option Income ETF (LSE: YMAP) is 27%, but this is dependent on the high level of tech volatility. To increase revenue, managers could sell more options, but doing so would raise risk and leverage. Nevertheless, there is undoubtedly a growing market for these funds in spite of these disadvantages.