dreaming of a second paycheck with covered call ETFs? We demystify the structure and hidden risks of these monthly dividend ETFs, which are popular for retirement investing. read before you invest.

why covered call ETFs are all the rage

covered call ETFs are a hot topic in the investment market these days. there are even products that promise to give you nearly $1 million in monthly distributions if you invest $100 million. With annualized distributions of more than 12 percent, they are attracting a lot of attention from people who are looking for stable cash flow in retirement.

this is especially appealing to retirees who are worried about managing their assets in retirement. the idea is that you can use the monthly distributions as a second paycheck to live on, but are they really safe? today, we'll break down the structure and hidden risks of covered call ETFs.

understanding the basic structure of covered call ETFs

covered call ETFs are as complicated as their name suggests. simply put, it's a derivatives investment that combines an equity investment with an options strategy: you own the actual stock while simultaneously selling call options on that stock to earn premium income.

here's an example let's say you have an instrument based on Samsung Electronics. if you sell a call option with a strike price of 70,000 won for 2,000 won, the option buyer pays 2,000 won and gets the right to buy Samsung Electronics for 70,000 won. the covered call ETF pays investors a monthly distribution from this 2,000 won premium.

this is easier to understand when compared to dividend ETFs: while a regular dividend stock investment only receives the dividend paid by the company, a covered call ETF receives the option premium in addition to the dividend, giving it a higher yield.

compare returns under different stock price scenarios

to better understand the characteristics of covered call ETFs, it's important to look at the return structure as the stock price changes. let's compare Samsung Electronics stock, call options, and covered call ETFs.

scenario 1: Stagnant stock price (stays at 70,000 won)
the covered call ETF investor keeps the option premium of KRW 2,000 as profit. the call option buyer loses 2,000 won by not exercising their right, and the spot stock investor makes no profit. In a sideways market, the covered call ETF is the most favorable.

scenario 2: The stock price declines slightly ($68)
the covered call ETF is the real deal. the spot stock investor loses $2, while the call investor loses $2 and the call investor also loses $2 in premium. the covered call ETF shows its defense against small dips.

scenario 3: Stock price rises slightly ($72)
the covered call ETF only makes a $2 profit. the stock is up $2, but you still have to hand over $72. The spot stock investor is out $2, and the call option buyer is out of pocket. in a bull market, covered call ETFs have limited returns.

scenario 4: Stock price spikes ($75,000)
here's where covered call ETFs fall short. while the spot stock investor makes $5,000 and the call option buyer makes $3,000, the covered call ETF still only makes $2,000. even if the stock price blows up, you don't get to enjoy the extra profit.

the real risk of covered call ETFs

many people think of covered call ETFs as a safe haven with less risk than investing in stocks, but that's a dangerous misconception.

they offer limited protection in a bear market
if the stock price drops to $65,000, the covered call ETF loses $3,000. the call option buyer only loses $2,000, but the covered call ETF investor is hit much harder. If the stock price plummets to $50,000? That's a huge loss of $18,000. the 2,000 won in option premium is powerless against the loss.

profits in a bull market are limited
even if the stock price soars to $100,000, the covered call ETF investor will only make $2,000. in a major bull market, you're looking at the cherry on top of the cake while a spot stock investor makes $30,000.

unproven crisis response
covered call ETFs have yet to experience a major stock market crash since they hit the market. it remains to be seen if they can continue to pay their promised distributions in a financial crisis-level crash - theory and practice can be two different things.

related article: How to build a safe portfolio for retirement
related article: a pre-investment checklist for monthly dividend ETFs
related article: Basic principles and caveats of derivatives investing

investment points for retirees to know

covered call ETFs are certainly an attractive product. but they should be approached with caution from a retirement investing perspective.

invest only a fraction of your total assets
relying on covered call ETF distributions for your entire living expenses is risky. place only 20 to 30 percent of your total retirement assets in them, and spread the rest between safe assets and cash.

compare products carefully
the newest covered call ETFs use different strategies. some pay lower distributions in exchange for higher upside, while others pay higher distributions with greater downside risk. read the prospectus carefully.

check the persistence of distributions
a high target distribution rate isn't always a good thing. Make sure the fund is structured to keep paying distributions even if market conditions turn bad, and that it's not paying distributions at the expense of principal.

common questions

Q1. Are covered call ETFs as safe as deposits?
A. No. Covered call ETFs are derivatives backed by stocks, so there is a risk of principal loss. there is no deposit protection, and you could lose a lot of money in the event of a stock market crash.

Q2. Do I have to pay taxes on the distributions I receive each month?
A. Yes, distributions are subject to dividend income tax. you may also be subject to capital gains tax, so be sure to do some tax planning.

Q3. Is now the right time to invest in covered call ETFs?
A. More important than market timing is your investment objective and risk tolerance. if you need a steady stream of cash flow and expect your stock price to move sideways, it's worth considering, but be aware that you'll be limited in a bull or bear market.

Q4. Which is better, investing in covered call ETFs or regular dividend stocks?
A. There are advantages and disadvantages to each. covered call ETFs have the advantage of high payout ratios but are limited in their upside, while dividend stocks have lower payout ratios but allow you to fully benefit from stock price appreciation. a mix of the two is also an option.

Q5. Will I lose my principal?
A. Yes. if the price of the underlying stock falls, the price of the ETF will fall as well. Even if you receive higher distributions, your overall return could be negative if the loss of principal is greater.

closing thoughts

covered call ETFs are an attractive investment that can provide a second paycheck, especially in sideways markets when stock prices don't move much.

however, retirement investing isn't foolproof - you can lose a lot of money when stocks plummet, and you can't take advantage of extra gains when stocks soar. it's also important to remember that these products have yet to experience the extreme volatility of the financial crisis.

savvy investors should understand both the benefits and risks of covered call ETFs, and invest only a small portion of their assets in them prudently. don't put all your eggs in one basket, and diversify your investments across a wide range of assets is the foundation of retirement wealth management.

please share your investing experiences or questions in the comments, and if you found this article helpful, please subscribe and like it.