Turning QQQ Into An Income Engine (NASDAQ:QQQ) (2024)

One feature of the current U.S. equity market conditions that does not get much attention is how expensive call options are - especially for tech stocks. Options cost more when market volatility is high and current options prices still incorporate the very high volatility of the COVID-19 decline in early 2020. For this reason, options are expensive as compared to more normal market conditions. In a recent analysis of options on QQQ, I find that the annualized option implied volatility on the Invesco QQQ ETF (NASDAQ:QQQ) is around 29% as compared to the trailing three-year volatility of 20.7%. Aside from COVID-driven volatility, prices of call options can also be driven up when some investors become exceedingly bullish, something we are seeing evidence of in the current market.

One benefit for investors when volatility is high is that covered call strategies (also called buy-write strategies) look more attractive. A buy-write trade involves selling call options against your long holdings, which locks in a certain amount of income. High volatility conditions result in buy-write strategies providing a higher-than-normal level of income. Quite simply, selling a call option against a stock or index fund means that you are selling off the upside potential in return for a specific level of income. Especially for investors who are concerned that equity valuations are getting uncomfortably high, this can be a very attractive strategy.

Selling Covered Calls Against QQQ

As I write this, QQQ is trading at $330.6. You can sell a January 21, 2022 call option on QQQ with a strike of $331 for $33.56 (that is the current bid price). This means that you can lock in an income stream of 10.15% for selling this (roughly) eleven-month call option against a position in QQQ (11.07% annualized). This is the entirety of the upside in this position, of course, because you have sold off the potential upside in QQQ. In general, one should expect that buyers of options will not exercise them early, so executing this covered call strategy should also provide you with most of the current yield on QQQ. This is only about 0.5%, but worth noting. With just two transactions, buying QQQ and selling the call option, investors can lock in around 10.6% in income over eleven months (11.6% annualized income).

In the example above, all of the potential price appreciation has been sold in exchange for the option premium because the strike price of the option is equal to the current price (this is referred to as an at-the-money (ATM) option). You could, however, sell a call option with a strike price above the current price and thereby retain the potential to benefit from price gains in the QQQ. The option premium you receive will, of course, be lower than if you sell the at-the-money call. The chart below shows the trade off between potential price appreciation and option income yield as the strike price increases.

Option income yield and potential price appreciation for QQQ buy-write with Jan. 21, 2022 call option

The example with the ATM call is on the far left side of the chart: lots of income yield but no potential for upside from price appreciation. These numbers reflect the current bid prices (the price someone is willing to pay) for call options on QQQ that expire on January 21, 2022.

QQQ Buy-Write ETF

For investors who don’t want to take the trouble to learn about options and manage the extra transactions, there are mutual funds and ETFs that implement covered call strategies (also called buy-write strategies) on major indexes. The Global X NASDAQ 100 Covered Call ETF (QYLD) is an ETF that runs a buy-write strategy against the NASDAQ 100 (the same index tracked by QQQ). This ETF attempts to replicate the performance of the CBOE NASDAQ 100 BuyWrite Index. QYLD sells at-the-money (ATM) one-month covered calls and rolls the strategy forward through time.

Because of the high level of volatility in QQQ, QYLD has a current annualized income level of almost 12%. Because this ETF sells a series of one-month call options, the actual future income depends on what the market and the volatility does over time. In other words, that annualized 11.7% “yield” is not locked in for any period greater than one month.

One-year price history and basic stats for QYLD (Source: Seeking Alpha)

I understand why the income generated by QYLD and similar funds is often shown in the same way as dividend yield and income distributions from bond funds, MLPs, and REITs, but potential investors need to understand that income generated from rolling monthly options sales are potentially much more volatile than any of these other forms of distributions.

With the rolling one-month options, there are a number of unintuitive outcomes that can occur. You might think that, in a year when QQQ declines, that QYLD is certain to out-perform QQQ due to the option income. This is not the case, however. In 2018, the total return on QQQ was -0.12% and the total return on QYLD (which includes the option premium) was -3.05%. This could occur, for example, if QQQ declined and then recovered some of its losses very quickly. Selling covered calls after a decline can mean you don’t benefit from the price recovery by as much as you lost in the decline.

QQQ total return (Source: Morningstar)

QYLD total return (Source: Morningstar)

Over the one-, three-, and five-year periods, QYLD has delivered decent returns but they are far below those of the QQQ. This is because this ETF sells all of the potential for price appreciation by selling ATM call options. This is not a criticism of the strategy, which is doing exactly what it is designed to do.

Summary

For those who believe that the QQQ is over-valued or just too exuberant, selling off some or all of the potential for additional price appreciation with a covered call strategy looks attractive. Call options are expensive because the expected volatility reflected in options prices (referred to as implied volatility) is high. Investors who would like to give up the potential for further price gains in exchange for realized income can do so either directly (selling call options against QQQ) or with a buy-write ETF that is based on QQQ (such as QYLD).

The math is very simple in demonstrating that, at current market prices, you can realize more than 10% in option premium income by selling a January 2021 ATM call option against QQQ. If you want to have the possibility of benefiting from some price appreciation, it is also simple to see the tradeoff between realized option income yield and potential upside return (as in my chart).

While the estimated annualized yield on QYLD is almost identical to the expected income from the Jan. 21, 2022 ATM covered call strategy outlined here, I prefer the latter because the income is actually locked in as soon as you sell the call on QQQ. In addition, QYLD has an expense ratio of 0.6%, which is not high but will reduce the total return that investors receive.

In summation, it is a good time to be generating income by selling off the market’s very optimistic hopes for future gains in QQQ, as reflected in high call option prices. While QYLD provides a reasonable way to explore this avenue for generating income from QQQ, I very much prefer executing a covered call strategy against QQQ directly. Many brokerages (if not all) make it very easy to execute a buy-write strategy on QQQ (or any other ticker). My overall rating on QYLD is neutral because I think investors will be better served by executing a QQQ buy-write themselves.

Geoff has worked in quantitative finance for more than twenty years.Before entering finance, Geoff was a research scientist for NASA. Geoff holds a PhD in Atmospheric Science from the University of Colorado - Boulder and a BS in Physics from Georgia Tech.Neither Geoff Considine nor Quantext (Geoff's company) are investment advisors. Nothing in any commentary here on Seeking Alpha or elsewhere shall be regarded as advice.