Investing in YieldMax ETFs

When I first heard that there was a Tesla ETF that was returning 68% annually, my immediate reaction was that it had to be a scam.

There cannot be a natural “68%” return on investment. Most of that had to be the return of capital, and the ETF would be worth nothing within a year.

But then I watched an interview with the fund manager that changed my mind. The fund’s investment technique seems to be valid.

Essentially, they are selling weekly covered calls against a stock with high implied volatility.

It’s all based on implied volatility

TSLA currently has an implied volatility (IV) of 50.85%. This means that if you buy or sell options that expire a month from now, there is a higher-than-expected premium. So, the market is giving TSLA a pretty high chance of making a big move up or down. It’s volatile.

If a stocks price was fairly predictable (say, in one month it will be $50 +/- $1), then the options market would not charge very much for the options as a premium. It’s a low-volatility stock. But if there was a big chance for variation in the stock price (say, $50 +/- $25), then the cost of the options will be a lot more.

So, some people sell options on high IV stocks and get a good return. And they accept high volatility in the underlying as the price for that.

For example, as I type this, TSLA is currently trading at $248.50. You can sell a $250 strike CALL option for Oct 6 2023, for $12.92. Every day, between today and Oct 6, that option is expected to fall

$12.92 / $248.50 is about 5.8%. You can make about 5.8% monthly selling at-the-money covered call options in TSLA.

Better than that, if you look at weekly options, you will get $5.06 for selling a $250 CALL option that expires next week. That is a 2.6% return on investment for selling a weekly covered call option on TSLA.

So, the 60% annual returns are not fake. They are selling rich options premium weekly on a volatile stock.

So, what can go wrong with YieldMax?

First, the stock itself can fall. If the stock falls from $245 to $240 in a week, you receive $5.06 from selling the call but lose $5 on the stock itself. So your profits evaporate. If the stock falls below $240, you’ve suddenly lost money on the week. And you’d have to sell a covered call the next week and potentially lose again?

Second, the volatility of the stock can fall. For example, hypothetically speaking, imagine TSLA continues consistently making money and growing every quarter, and Elon Musk is no longer tweeting crazy things. After 3 months, 6 months, and 9 months of stability, maybe the IV falls from 50% to 25%, and the options prices fall as a result. So the 3% per week goes away.

Third, the stock could go up dramatically. Now, of course, you still make a profit on that. But the profit is not as much as it could have been. The actual cost here is that you are sometimes better off holding the stock and NOT selling options against it.

Over months and years, I’ve seen that some covered call ETFs (the BMO ones) underperform the underlying stocks.

But with a high return on investment (20%, 30%, 40%, 50+), that becomes less of a concern. So, the stock gained 100% in a year? You still gained 60%.

What’s the key then?

The key is that you have to believe in the underlying stock. If the biggest risks come from the stock falling and never recovering to the previous levels, then you need to do this with a stock with a lower risk of falling.

Essentially, this requires you to bet that the underlying stock is actually less volatile than the market prices it at.

You’d need to make a list of every stock with high implied volatility, and pick the 3 or 4 stocks where the market is panicking over nothing and the actual risk is less. But then, if the market starts to agree with you, the rich options premium goes away!

I don’t think Tesla or Nvidia are great examples of this. Those stocks are overpriced relative to maximum potential earnings. Those stocks can fall with a bad earnings report or a fight between the USA and China. They are volatile.

I’d much prefer to do this in “stable” tech stocks. These stocks still have the high IV of the tech sector but are not suddenly going to be losing money with no way to recover.

I bought some of the YieldMax Microsoft Covered Call ETF (MSFO) and the YieldMax Amazon Covered Call ETF (AMZY).