"‘Living on Dividends in Retirement’... Is Covered Call ETF a Panacea? [Seungseop Song's Financial Light]"

'Covered Call ETF' Enabling Monthly Dividends
Popularity Rises Despite 'Limited Gains, Unlimited Losses'

Monthly dividend ETFs are gaining tremendous popularity. The fact that dividends are received every month has attracted early retirees, leading to a flood of funds into the market. Among many monthly dividend ETFs, products using the 'Covered Call' strategy are especially popular. Most of the highest-yielding ETFs employ the covered call strategy. What exactly is a covered call, and how has it attracted investors' money?

First, you need to understand the structure of a covered call. Imagine you bought one share of stock A for 10,000 won. Normally, to make a profit, you would wait for stock A to rise. But if you want to make an immediate profit, you might approach a friend and propose this: "I'll give you the right to buy stock A from me at 10,000 won a few days from now. In return, just give me a premium of 1,000 won." Buying the asset while simultaneously selling the 'right to buy' the asset is exactly what the covered call strategy entails.

The covered call strategy shifts who profits depending on the underlying asset's price. Suppose stock A rises to 20,000 won. Although the price increased, you promised your friend to sell the stock at 10,000 won. If you had just held the stock, you would have earned 10,000 won, but because of the covered call strategy, you only earned the premium of 1,000 won. You made a profit, but it can feel disappointing.

Conversely, imagine stock A drops to 5,000 won, half its original price. Your friend would likely not exercise the purchase right. After all, they only have the right to buy, not the obligation. Your stock's valuation would have decreased from 10,000 won to 5,000 won. However, you could partially offset the loss because you received the 1,000 won premium from your friend.

But stock A might also stay flat at 10,000 won. Normally, you wouldn't have made any profit. However, since you granted the purchase right to your friend and received 1,000 won as compensation, you earned money without any stock price increase.

Profit is limited, loss is unlimited... Entering blindly leads to losses

Did you notice the most prominent feature of the covered call in these three scenarios? It is that the 'premium is always collected regardless of price.' Thanks to this characteristic, the advantages and disadvantages are clearly divided. The advantage is that it can generate high distributions. If you simply invest in stocks and bonds, you only receive dividends and interest, but with the covered call strategy, you can also generate premiums. This is why monthly dividend payments are possible thanks to the covered call strategy.

It is also advantageous in a 'sideways market' where prices neither rise nor fall. It is difficult to make profits in a sideways market, but covered calls earn premiums. In a declining market, it helps reduce losses somewhat because you have the money earned from premiums.

However, the covered call strategy is not always advantageous. It has a critical weakness. The covered call strategy has a 'limited profit, unlimited loss' structure. No matter how much the asset price rises, you can only earn the premium. On the other hand, if the asset price falls, you can lose your entire principal. Even if you receive many distributions, if the price drops accordingly, you will incur losses.

Of course, in reality, not all asset management companies sell exactly the same covered call ETFs. The assets invested in and management methods vary widely. Some products are designed to partially follow price increases by compensating for various drawbacks. Therefore, covered call ETFs should also be purchased after thorough analysis and consideration. Starting investments blindly while imagining receiving monthly dividends in retirement could lead to significant losses.