While the trading and tax advantages of ETFs are typically well known, the ability to trade options on an ETF is an underutilized benefit of these flexible funds. Option strategies are typically reserved for professionals, but I’ll run through a few basic strategies below that can be implemented by anyone investing in ETFs.
Basic option strategies may be used to manage risk and/or enhance income in an investment portfolio. These strategies are built with put and/or call options.
A put is an option contract that gives the owner the right, but not the obligation, to sell a specified amount of an underlying asset at a set price within a specified time. The buyer of a put option estimates that the underlying asset will drop below the exercise price before the expiration date.
A call option is the flip side. It gives the owner the right, but not the obligation, to buy (under the same conditions above). The buyer of a call option estimates that the underlying asset will rise above the exercise price before the expiration date.
So why use option strategies with ETFs?
1. Manage Risk
Put or call options may be used to keep risk in check. This is how it works:
Buy Put –Buying a put option is similar to buying insurance on a portfolio. For a small fee, the downside risk of an asset is limited to the strike price on the option minus the cost of the put.
Sell Call – Selling call options on a security that is held in a portfolio is called a buy/write strategy. An ETF is bought and held in the portfolio. Then a call option is written (sold) on the underlying ETF. By selling a call option on the ETF, the downside of the holding is minimized by the amount of income generated from the sell of the call option.
2. Enhance Income
These options may also be used to generate extra income. A couple of simple strategies include: