INVESTING TRUTHS
Covered Calls Are a Devil’s Bargain — The Income Trap Most Investors Ignore
Why steady income from covered calls may come at a hidden price.
Aditya Kumar13 min read·Just now--
The idea that covered calls generate income is a financial one. These strategies are mechanically expected to underperform their underlying equity, and increasingly so at higher targeted distribution levels.
For long-term investors, covered calls increase risk by leaving the downside unprotected while capping the upside, eliminating the mean-reverting behavior of stocks, an important feature of stock returns.
Why the so-called passive income from covered calls is a devil’s bargain.
The preference for income is one of the strongest behavioral biases in investing.
It can make people do silly things in their search for income. Some investors look for funds that pay high distributions.
This is well known by fund managers who use high distribution yields to attract investor dollars.
The problem for investors is that marketing these yields, in the case of covered calls, as income or even worse as expected returns, is financial. It is not a lie, to be clear.
It is indifference for the truth. Selling a high distribution yield as an expected return ignores the fact that yields on covered call strategies are inversely related to their expected returns.
Higher yields mechanically mean lower expected total returns. Total returns, to be clear, are what you need to buy groceries.
- Why distribution yields are not returns,
- How covered calls reduce expected returns,
- And why I think the return profile of covered calls makes them particularly risky for long-term investors.
To avoid being too theoretical, I’m also going to go through the performance of a bunch of covered call funds to show that what I’m saying is not just theoretical. It is exactly what’s happening in the live funds.
Selling a call option on an equity that you own generates income and creates a liability that empirically more than offsets the income received.
This makes the distribution yield uncovered call funds a misleading metric.
Selling a call option means selling the right to buy the underlying stock at a predetermined price called the strike price in exchange for a premium.
An equity covered call strategy invests in stocks and sells call options on those stocks.
A fund using the strategy typically distributes the derivative income from selling calls as cash to investors, resulting in its high distribution yields.
While those distributions may feel like investment returns, selling the call is only the first step in the trade. The fund has sold the right to buy the underlying stock at the strike price.
If the price of the underlying rises above the strike price, the option holder, to whom the fund sold the option, will exercise their call option, and the fund will have to sell the stock at a price below its market value, putting a cap on upside returns.
I want to dig a little deeper into the mechanics of what’s going on from the perspective of expected returns.
Call options are positively exposed to their underlying equity, measured by a term called delta.
Buying a call option on a stock gives you positive exposure to the price movements of that stock.
Selling a call on an asset that you own, a covered call, reduces your exposure to the underlying stock.
You’re shorting exposure to the underlying equity by selling the call option.
Holding option maturity constant, call option prices and deltas monotonically increase with decreasing strike price.
If you want a higher income on your covered call strategy, you can sell options with lower strike prices, resulting in higher income and, importantly, higher short delta. This is crucial in understanding how yields are related to expected returns.
In simple terms, a higher yield mechanically means lower exposure to the underlying asset by being short a higher delta option, and correspondingly, it means lower expected returns.
When you sell the call option, you receive an option premium that feels like income and is packaged up and distributed by covered call funds as a cash distribution.
But the fund now has this liability, the potential need to sell the underlying shares below their market value if the price rises above the strike price. This liability exists until the position is sold or the option expires.
Remember, the expected return of the short call is increasingly negative with an increasing derivative yield.
Here’s why this matters.
Over the full life cycle of this type of trade, the outcome is generally worse than simply having held the underlying equity. Part of the reason is a lower equity beta, meaning less exposure to the equity risk premium.
To be clear, this is something that you could do by simply reducing your exposure to the stock directly and holding some cash. I’ll come back to that with an example later.
The problem is that the reduction in exposure to the equity risk premium is also asymmetric. You keep most of the downside while capping your upside at the strike price.
This means that through any periods of market volatility, which are of course common in equities and stocks, you eat most of the downside, but you do not participate in a large portion of the upside.
Systematically missing out on stock market recoveries, which are common after major downturns, can be very expensive.
Before I continue, I do need to mention a potential saving grace for covered calls. The volatility risk premium.
Equity options tend to be priced with an implied volatility higher than realized volatility.
This creates the opportunity for option sellers to earn an expected risk premium for enduring the risk of an extreme event where realized volatility exceeds implied volatility.
While it makes back-tested covered call strategies look really good in recent history, since about 2011, the volatility risk premium has not been anywhere near sufficient to offset the reduction in equity exposure from selling the options, resulting in poor performance for these strategies.
This kind of thing can happen when a trade becomes too crowded by, say, the proliferation of retail funds chasing the strategy.
I want to make sure it’s really clear that the point about asymmetry is particularly important for long-term equity investors who have historically benefited from a little bit of mean reversion in stocks, making stocks a little bit less risky at long horizons than they would be if returns were completely random.
In simple terms, after stocks have performed really poorly, they tend to perform a bit better than average.
This is in contrast to bonds, which do not tend to have the same rebound effect after poor performance.
In fact, bonds often continue having poor performance after having poor performance.
But here’s the problem. Selling calls on your equity positions both lowers the expected returns and eliminates the mean-reverting tendency of stocks by capping the upside return while only slightly improving the downside by the amount of the option premium. Again, getting most of the downside with a limit on upside is not good.
I would argue that it makes covered calls very risky for long-term investors who are concerned with funding their inflation-adjusted spending.
This might be hard to believe given the large distribution yields of these strategies.
But it’s important to remember that these distributions are not income in the way that bond interest is, and presenting them this way is irresponsible.
The option premiums come with an associated liability that lowers expected returns and transforms the shape of the distribution of returns into something much less favorable for long-term investors.
One of the biggest problems I see for these funds is that their distribution yields are often much higher than their total expected returns.
Yet, they’re occasionally discussed in income investing and fire communities as if their distributions are perpetually sustainable.
The combination of high distribution yields, lower expected returns, an uncapped downside, and a capped upside means that someone who’s spending the distributions could deplete their capital fairly quickly.
This is another reason why calling these distributions passive income is financial.
If you need a psychological trick to help you spend down your capital, covered calls might be the answer, but their distribution yields are not a sustainable source of long-term income. I’ll say it one more time. Covered calls are not good for long-term investors.
Stocks have positive expected returns and mean-reverting tendencies. Covered calls reduce exposure to the underlying stocks and chop off the right tail of the distribution of returns, capping the ability of the underlying to recover from downturns.
This effect compounds over time, driving an increasingly large wedge between the performance of the covered call strategies and their underlying equities.
This is true in any market conditions. I often hear that covered calls are great in a sideways market, but equity markets don’t go sideways.
They are volatile even over periods where they have flat returns. Every time your covered call strategy eats downside and is denied upside, you are losing.
Let’s look at some live funds. There are quite a few covered call ETFs with reasonably long histories to examine.
These can be compared to ETFs investing in the underlying equities without selling calls to see all of the points I’ve made so far happening in live products.
I looked for covered call ETFs with a minimum 10-year history. Beimo has a few that launched in 2011. The Beimo covered call utilities ETF launched on October 20th, 2011. It currently has a distribution yield of 7.37% compared to 3.43% for an ETF of the underlying equities.
In periods where the underlying equities do not perform well, the covered call fund has been able to outperform, but these periods have tended to be brief, and in the long run are far more than outweighed by the capped upside.
Over the full history since inception, the covered call fund has trailed the underlying by an annualized 2.6 percentage points.
And it has trailed the underlying in more than 70% of three-year rolling periods with a one-month step.
Increasing the rolling window to four years results in the covered call fund trailing nearly 85% of the time.
The underperformance is particularly pronounced when the underlying equities drop dramatically and then recover, which is a pretty typical characteristic of equity returns.
As I mentioned earlier, I also mentioned earlier that reducing equity beta by holding cash can get you to a similar place as a covered call, at least from the perspective of beta.
I ran a portfolio of 60% Beimo equal-weight utilities and 40% cash, a well-high-interest savings account from October 2013 through August 25th 2025.
You can see they track pretty closely most of the time, except that the covered call fund gives up extreme upside events and eats the whole meal on the downside.
I won’t keep repeating that equity plus cash comparison, but Jeff Pac, managing director for Morning Star Research Services, recently showed in a sample of 22 single stock covered call ETFs that a combination of cash and the underlying stock outperformed most of the funds, had lower volatility than all of the funds, and had a higher Sharpe ratio than most of the funds.
Another Beimo fund with a reasonably long history is the Beimo Covered Call Can Canadian Banks fund. It launched January 28th, 2011.
It has a current distribution yield of 6.13% compared to 3.61% for an ETF of the underlying equities.
It has underperformed by an annualized 2.71 percentage points since inception, and it has only outperformed in less than 1% of rolling 3-year periods since inception.
The Global X S&P TSX 60 covered call ETF launched on March 16th, 2011. It currently has a distribution yield of 7.67%.
It has trailed the EyesShares S&P TSX 60 ETF by 3.65 percentage points since inception, and it has trailed in 92% of three-year rolling periods since inception.
I can go on, but you get the idea. Covered calls are not good for long-term investors who expect positive returns from the underlying assets.
The ones I have mentioned so far are pretty tame with distribution yields in the 6 to 7% range. I think where these products really go off the rails is when they push for even higher yields.
Remember from earlier, if you want a higher income on your covered call strategy, you can sell options with lower strike prices, resulting in higher income and higher short delta.
In other words, targeting a higher income exacerbates all of the issues I’ve mentioned with covered calls. Lower strike prices result in higher distribution yields, less exposure to the underlying equity, and a tighter cap on upside performance.
Hamilton ETF’s yield maximizer ETF series targets yields well over 10% by selling at-the-money call options. Take their US equity yield maximizer ETF as an example.
It targets a distribution yield of 12% and has underperformed an S&P 500 ETF by an annualized 4.48 percentage points over its admittedly short history.
I also want to mention JAPI. This is JP Morgan’s equity premium income ETF. It gained a cult-like following around 2022 when it outperformed the S&P 500 by nearly 15 percentage points.
That, combined with its prominently marketed high distribution yield, has made it extremely popular with retail investors in general and income-focused investors in particular. It even has its own subreddit.
The problem is that, like other covered call strategies, it has underperformed an S&P 500 ETF.
In this case, by 5.92 percentage points since inception in May 2020. This one’s not a perfect comparison to the underlying equity since JAPI’s underlying equity portfolio is actively managed.
I don’t know if blaming the underperformance on active management or uncovered calls is worse, but in either case, we know these things generally don’t play out well for investors in the long run.
The most recent and ridiculous development I’ve seen in the covered call space is single stock covered call ETFs.
These are exactly what they sound like, covered calls on single stocks in an ETF wrapper.
Some of their distribution yields are astronomical, but as you might expect by now, so is their underperformance.
TSLY writes covered calls on Tesla shares. Its distribution rate at the time of writing is 48.59%. But since its inception on November 22, it has underperformed Tesla by more than 20 percentage points annualized.
These numbers are ridiculous, but they certainly do highlight the previously mentioned relationship between high derivative income yields and low expected returns.
The last point worth mentioning is that covered call funds will tend to have higher fees and transaction costs than funds holding their underlying equities.
For the sample of funds that I mentioned in this story, excluding the single stock fund, the average management expense ratio is 0.63%. 63%, and the average trading expense ratio is 0.16%.
While funds holding the same underlying equities have an average management expense ratio of 0.25% and an average trading expense ratio of 0%.
You are paying a significant premium to access all of the downsides of covered calls.
Those high-income distributions have to be really, really psychologically important to you for all of this to make sense.
For completeness, I do want to say that some investment managers may successfully use covered calls to access the volatility risk premium, but this is a fairly esoteric risk premium that is probably not required for the typical household saving for or living in retirement.
Even if there is a volatility risk premium worth pursuing, covered call funds are typically marketed to retail investors based on their distribution yields, not their exposure to the volatility risk premium.
In my opinion, selling these products on their yield, which in the case of covered calls is inversely related to their expected returns, shows indifference to the truth.
It is bullit, especially when it’s held up next to things like treasury bill yields.
Taken together, covered calls don’t have anything special to offer. They get you to a place similar to holding a bunch of cash, except that your upside is limited and your downside is unlimited.
They’re more likely to be detrimental to most investors' expected outcomes than to improve them.
Their high yields come at the expense of lower expected returns and historically lower realized returns.
The volatility risk premium, which could theoretically help covered calls recoup their lower expected returns, has not been anywhere near sufficient to offset the reduction in expected returns since around 2011.
All of these downsides show up very clearly in the terrible long-term performance of live covered call strategies when measured properly by their total returns.
