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Using Options Strategies With ETFs

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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:

Sell Call – If a security remains below the call strike price prior to expiration, the ETF holder keeps all of the income generated and realizes the price return from the underlying ETF. The primary risk with selling calls is if the ETF rises above the call price, the opportunity for upside return is capped.

Sell Put – Selling a put will generate income immediately. In this scenario, the seller does not hold the underlying ETF but will need to purchase the ETF from the put buyer if the ETF price falls below the strike price. As long as the ETF price stays above the strike price, there is no need to purchase the underlying ETF and the seller banks extra income to his/her portfolio.

These basic option strategies are just a sampling of techniques that can enhance an ETF portfolio’s opportunities. Individuals may also buy calls to speculate that an ETF will rise in value with a small amount of money. Hedge funds will often employ this leveraging technique. Collars, condors, butterflies, and calendars are more complex strategies that help manage risk or generate income in the portfolio.

A few key factors must be considered when implementing an options strategy with an ETF portfolio: liquidity, volatility and risk.

Liquidity

More than 500 ETFs have open interest on the Chicago Board Options Exchange. However, only eight ETFs have traded an average daily volume above 100,000 option contracts in the past 20 days, and 39 have traded above 10,000. Liquidity is best for very broad-based ETFs with large assets under management and large ETFs that offer significant volatility. SPY, the SPDR S&P 500 ETF, offers by far the largest option volume of any ETF. Volatility

Volatility is key to generating option activity and obtaining premiums on income generation. Since 1990, the VIX index has ranged from 10.4% to almost 60%. Volatility peaked in late 2008 when equity markets plunged during the financial crisis. When volatility is high, option activity picks up because investors are interested in hedging their portfolios and desire low-cost opportunities to profit in market swings.      

Risk

A covered-call strategy offers the lowest risk because it does not require leverage to implement. However, even though the downside price movement is cushioned by income, there is nothing to stop the ETF price from plunging in the portfolio.

Inverse ETFs can also offer liquidity in the option market. Traditional individual stock portfolios with an option strategy may be quite risky as they are fully exposed to the equity market. By integrating inverse ETFs with an option strategy, overall exposure to the equity market may be hedged while generating additional income in the portfolio.

There are many ways to enhance a traditional, diversified portfolio. With an ETF portfolio, options are another way that investors may seek returns. The strategies outlined above may be implemented by individual investors and professionals alike.  As with any options strategy, take caution in understanding the risks and rewards.