Most of my clients are approaching retirement or are already retired. Many of them reflexively assume that they should live off of the “income” on their investments. This unfortunate bifurcation of total return into income and capital appreciation makes them dividend-seeking investors. With bond yields so low, many are turning to yield-oriented equity investments. Unfortunately, many times these investments may be selected on the basis of yield alone. Investments at the top of the yield heap often come with a lot of downside risk. Global X Nasdaq 100 Covered Call ETF (QYLD) is a case in point. This fund sports a yield of 10%-12%. But the source of the yield is not dividend income on the underlying stocks. Instead, it is option-writing premium income, which gives the fund a very asymmetrical return profile—truncated upside and unlimited downside. There are reasons to own QYLD at times, but it is important to understand when and why.
How QYLD Works
As its name implies, the Global X Nasdaq 100 Covered Call ETF (QYLD) follows a “covered call” or “buy-write” strategy. The Fund buys the stocks in the Nasdaq 100 Index and “writes” or sells corresponding call options on the same index. Like most ETFs, this is a passively managed fund that seeks to track an index, in this case, the CBOE Nasdaq 100 BuyWrite V2 Index. The fund’s expense ratio is .60%.
Specifically, each month the fund sells at-the-money calls on the Nasdaq 100 Index that expire in the following month with a notional value equal to 100% of the Fund’s long positions in the underlying stocks. The calls are sold the day before option expiration, generally on the Thursday before the third Friday of the month. Option trades are spread throughout the day at the VWAP (volume-weighted average price). The call options sold are European call options which cannot be exercised early. This cycle is repeated monthly.
The economics of the strategy are as follows:
- The Fund does not participate in much of the potential upside volatility of the Nasdaq 100 because of the call options sold.
- The Fund retains nearly all of the downside volatility of the Nasdaq 100.
- The Fund collects premiums on the call options sold.
Two Risk Premiums
Most investing is about the collection of various risk premiums—the rewards that the market offers for accepting risks of various kinds. By far the most important risk in most portfolios is equity market risk, which is rewarded with the equity risk premium—the extra return that the stock market achieves above the risk-free rate over time.
Equity market risk dominates most portfolios and explains 90% or more of the volatility of most diversified portfolios. One problem investors have is finding ways to adequately diversify equity market risk. Bonds have historically played a major role, but bond yields are now so low that they are not very attractive investments.
Buying QYLD is a way of investing to two different risk premiums:
- Equity risk premium
- Volatility risk premium
Selling options is one way to harvest the second type of risk: volatility risk. Options are priced on the basis of their “implied volatility.” The higher the expected volatility, the higher the value of the option sold. The price that the option writer is paid is called the “premium.” The price of an option is the sum of its “intrinsic value” (to the extent that it is “in the money”) plus “extrinsic value” or “time value.” For example, if QYLD sells NDX (Nasdaq 100) call options “at the money” (which is their practice), that means that they sell call options with a strike price equal to the current price of the Nasdaq 100. At-the-money call options have no intrinsic value, only time value. Their time value reflects the possibility that the price of the index may be above the strike price at settlement, which is about a month in the future when the options are sold by QYLD.
When options are sold, neither the buyers or the sellers know what the actual volatility of the underlying index will be in the period between then and the expiration. Usually, investors estimate the expected volatility based upon the recently realized level of volatility of the underlying. However, the prices of options imply a level of future volatility that is almost always above that of recently realized volatility. This extra compensation paid to the sellers of options varies over time, and is what is commonly called the “volatility premium.”
Historically, the implied volatility of Nasdaq 100 options has been somewhat above the actual trailing volatility of the underlying index. In this sense, options have been consistently “overpriced.” One reason that options may be overpriced is because they provide small investors with a leveraged investment opportunity, making options more attractive to undercapitalized investors who value this attribute. The other primary reason that options may be overpriced is because option sellers must be compensated for the risks involved.
The orange line in graph above depicts the CBOE Nasdaq 100 Volatility Index (VXN), which is based on the implied volatility of near-the-money puts and calls using a constant-maturity of 30 days. The blue line shows the exponentially-weighted 60-day trailing volatility of the daily returns of the Nasdaq 100 Index (NDX). (I tested several variations of the trailing historical volatility and found that the exponentially-weighted 60-day trailing volatility had the tightest statistical relationship with CBOE option-implied volatility among the variations that I tried.)
Note that the orange line is usually above the blue line. This indicates that the options market consistently prices option volatility (and therefore option premiums) above the level of actual volatility. Since 2000, option-implied volatility has been on average 116% of actual volatility, or about 3.8% higher. This provides option sellers with a potentially profitable option-selling opportunity. However, there are risks involved. The risk for call writers is that the underlying will move up above the strike price. The risk for put writers is that the underlying will move down below the strike price.
Again, buying QYLD is really a way of collecting these two risk premiums: 1) the equity risk premium and 2) the volatility risk premium. However, I believe that only a small percentage of the owners of QYLD actually understand this. To most of them, it is all about “yield.”
Why QYLD is So Popular
I am concerned that many investors, and even advisors, misunderstand the nature of this fund. They may believe that they are getting a huge dividend yield on top of owning the stocks in the Nasdaq 100 Index. In fact, they have very limited upside. Instead, they are getting a modest option premium and nearly all of the downside potential from owning the Nasdaq 100 stocks.
As of this writing, the Global X website for QYLD lists the “distribution yield” for the fund at 10.36% and the trailing 12-month yield at 12.28%. I have no doubt that this eye-popping yield has a lot to do with the fact that the fund has ballooned to $4.5 billion in AUM.
Obviously, that kind of yield does not come from dividends on the Nasdaq 100 stocks held by the fund. By comparison, the 30-day SEC yield for Invesco QQQ Series Trust (QQQ), a fund that tracks the Nasdaq 100 Index, is only .48% (as of June 30, 2021). The SEC yield for QYLD is only .09%, by the way, so very little of the actual dividend yield is distributed to fund shareholders. What is distributed are the premiums received from monthly option writing, but this source of income is not counted under the SEC definition of yield.
The QYLD website has “Supplemental Tax Information” that mentions the fact that “the fund expects to distribute on a monthly basis one-half of the premiums received by writing calls on the Nasdaq 100, capped at 1% of the Fund’s net asset value (NAV).” As long as the option premiums for writing NDX calls hold up, it seems likely that the Fund’s monthly distributions will be in the neighborhood of that 1% cap, giving the fund a distribution yield of close to 12% per year.
Analyzing QYLD Returns
The graph above illustrates the monthly price and total returns (including distributions) for QYLD since its inception on December 12, 2013. Although the total return has been 8.85%, the price return has been -1.35%. That is, the price has actually declined. For comparison purposes, I indexed QQQ total returns to the same starting level. Obviously, QYLD has not participated in most of the upside of the Nasdaq 100 Index.
The option premiums provide a bit of a cushion on the downside, but only to a very limited extent. To describe QYLD as “defensive,” or as providing “downside protection,” is to misrepresent its nature.
The graph above shows the monthly returns of QYLD compared to QQQ since the inception of the fund. Note that the positive months for QQQ generally show truncated positive returns for QYLD. Note also that the months with the most negative QQQ returns also had very poor QYLD returns, and in some cases, QYLD had even more downside volatility.
Admittedly, the two months in which QYLD had more downside volatility than QQQ were very unusual months: February and March of 2020. In these months, the market was dealing with the unfolding of the Coronavirus pandemic and was extraordinarily volatile. Still, how could QYLD have collected an option premium and still have had more downside than QQQ? It has to do with the fact that my database is based on calendar months, but the monthly option writing cycles actually began and ended on the third Friday of each month. Consequently, there is some slippage between the two. For example, in February 2020, the Nasdaq 100 Index increased during the early part of the month, so QYLD did not garner much of this climb. However, in the latter part of the month, the index plummeted, and QYLD was fully exposed to the drop.
The graph above has the same monthly returns, but in this presentation they have been sorted by QQQ returns from highest to lowest. This makes clear the nature of QYLD—truncated upside but full (or nearly full) downside. As expected for a call writing fund, the best relative results are when the Nasdaq 100 Index is essentially flat. In those months, the option premium that QYLD collects enables the fund to outperform QQQ.
Estimating QYLD’s Option Writing Premiums
Owning QYLD is essentially a way to sell call option volatility on the Nasdaq 100 Index. As such, it is a more attractive investment when the option premiums being offered are high. It is not very practical to go back to the fund’s inception and try to reconstruct what the actual option premiums were on each monthly roll date. Instead, I estimated the monthly option premium with the following formula:
Estimated QYLD Call Option Premium = QYLD return if QQQ is return was positive OR
= QYLD return – QQQ return if QQQ return was negative
Taking another look at the graph above, for nearly all of the months in which QQQ return was positive, QYLD return was also positive, but typically only modestly positive. There were a two exceptions: October 2014 and June 2018. No doubt the explanation is the slippage between calendar monthly returns and the actual option writing monthly cycle.
Even with the “slippage” problem, I believe that the above formula is a reasonable rough approximation of the return from QYLD’s option writing premiums. My research objective is to try to identify one or two variables that help to explain when the option premium is high vs low.
When to Invest in QYLD
Obviously, you do not want to invest in QYLD if the Nasdaq 100 Index is going to decline by much, since the fund is 100% exposed to the downside in the index, net of the income derived from option writing. However, for the present purposes, I am assuming that forecasting the return of the Nasdaq 100 is essentially impossible.
On the other hand, the estimated option premiums are always positive, and tend to vary around a central tendency that appears to be in the area of 2%.
Given that option writing premiums are the lion’s share of QYLD’s returns, is there a way to forecast when those premiums will be above-average, and when they will be below average?
My initial theory was that the difference between the level of option-implied volatility (VXN Index) and trailing historical daily realized Nasdaq 100 Index volatility would be a very good predictor of both estimated option premium level and QYLD total return. I was mistaken. The expected-realized volatility spread turned out to be relatively useless in predicting either.
However, what did turn out to be powerful was the level of the VXN Index relative to its own trailing long-term history. My own favorite method for calculating the long-term average of any time-series variable is the trailing 120-month (10-year) exponentially-weighted moving average. As shown below, the correlation between month-end current minus L/T trailing VXN had a 28% correlation to the estimated option premium. This makes perfect sense if option premiums rise and fall with the level of volatility. I have labeled this variable X1.
The other variable in my model, X2, has essentially a zero correlation with X1, but is conceptually somewhat of an inverse to X1. Here, the variable is defined as the 5-day moving average of VXN minus the current VXN. The idea is that you do not want to be selling calls if the VXN is rising rapidly. Instead, wait until VXN is somewhat below its 5-day moving average. Better yet if VXN is falling and the current level is well below its 5-day moving average. This variable has a 32% correlation to the month-ahead estimated option premium.
Mathematically, with both X1 and X2 in a model, the positive influence of VXN on X1 cancels the negative influence of VXN on X2 and VXN itself drops out on a net basis. Thus, the highest expected premium income occurs when the 5-day VXN level is very high relative to the 120-monh VXN level. That is, when VXN is high, but is below its 5-day moving average. The highest expected option premiums and therefore the best time to own QYLD is just after a volatility spike when volatility is still high but on a near-term downtrend.
The Current Outlook for the Fund
At present, both X1 and X2 are somewhat negative. X2 is more of a short-term timing variable of course. X1 (current VXN minus its 10-year average) has collapsed since the Covid-19 pandemic and is now about -2.4%, a definite bearish signal for QYLD. If you own the fund, it may be time to look for an exit.
Summary and Conclusions
- QYLD is a play on the volatility premium earned by selling option volatility
- Its exceptionally high yield is not based on dividends
- The fund earns all of its income from call writing
- Higher option-implied volatility means higher premiums and higher returns for QYLD
- The best time to own QYLD is when VXN has recently spiked but is on a near-term downtrend
- The fund is fully exposed to downside returns in the Nasdaq 100 Index net of the option income
- At present, the VXN Index is below-average, a sell signal for QYLD