Published date: 19th August 2025 | Author: Tom Bailey
What are covered calls?
Covered call ETFs follow a simple two-part approach:
But before we explain how this works in an ETF, it’s helpful to first understand what a covered call is.
A call option is a contract that gives someone else the right – but not the obligation – to buy a stock from you at a set price (called the strike price) before a certain date. In return for that right, the buyer pays you a fee, known as a premium.
Let’s say you own a share of Apple, currently trading at $100. You decide to sell a call option with a strike price of $105 that expires in one month. An investor called Victoria buys this option from you and pays you $2 for it – known as the premium.
By the end of the month, two things could happen:
This is the basic idea behind a covered call: you own the stock, and you “cover” the call option by being prepared to sell it if required.
Covered call ETFs do this at scale – they own a basket of stocks and sell call options on them, typically repeating the process each month. The regular income from the premiums can provide investors with an income stream. But there is a trade-off: when markets rise quickly, the strategy may give up some of the upside, since gains above the strike price are capped.
How do covered call strategies work in an ETF?
Covered call ETFs use the same basic idea as the above Apple example – but they do it across a whole portfolio of stocks.
Here’s how it typically works:
By following this pattern, the ETF earns income month after month from selling options. That income can be passed on to investors. However, there is a trade-off: if the market rises sharply, the ETF may miss out on some of the gains, since it has agreed in advance to sell the stocks at a fixed price.
Covered call ETFs are designed to generate regular income, which is their main attraction.
Here are a few reasons why they’ve become popular:
The importance of volatility
One of the biggest factors affecting how much income a covered call ETF can generate is how much the market is moving, known as volatility.
Volatility simply means how much prices are expected to rise or fall over a short period. When markets are calm and prices barely move, there’s not much opportunity for option buyers. But when markets are jumpy – with frequent ups and downs – buyers are willing to pay more for the chance to benefit from those swings.
That’s important for covered call ETFs because the money they make from selling options – the premium – is higher when volatility is higher. In short: More movement in the market = more income potential from selling options.
Since 2020, markets have been more unpredictable than they were in the previous five years. This greater volatility has helped covered call ETFs generate stronger income – and is one of the reasons why these strategies have grown more popular.
As the chart below shows, average market volatility, as measured by the VIX index, has risen since 2020. From 2015 to 2019, the average VIX level was just over 15. Since 2020, it has averaged more than 21. That may not sound dramatic, but the impact on option pricing is significant.
Source: REX Shares; CBOE. Data as of 02.01.2015 – 30.05.2025. For illustrative purposes only.
How covered calls perform in different market environments
Covered call ETFs don’t aim to beat the market in every condition. But they can be especially effective in certain types of environments. The image below shows how they typically behave across four common market scenarios.
Source: Rex Shares. For illustrative purposes only.
When the market rises quickly, a covered call strategy may underperform the broader market. That’s because the ETF has agreed in advance to sell some of its stocks at a fixed price – so it gives up some gains if prices rise sharply. The fund still earns income from the options, but it won’t fully capture the rally.
This is often where covered call ETFs perform best. The underlying stocks rise gradually, staying below the option strike price. That means the ETF keeps the stock gains and the income from the options, resulting in a potentially strong overall return.
In markets that go nowhere – bouncing up and down but not making real progress – covered call strategies can shine. Even without price gains, the ETF continues to earn income from selling options. That steady cash flow can make a big difference when markets are stagnant.
Covered calls won’t prevent losses when markets fall. But the income from selling options can help reduce the impact. While the underlying stock values may decline, the extra income can soften the blow – and in some cases, offset part of the loss.
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