3 Reasons To Use Options On ETFs

August 01, 2016

Exchange-listed options are versatile financial instruments that are well-suited for the prudent tailoring of risk and reward in investment positions.

In a media environment hungry for easy answers to complex issues, this is not a message investors hear very often, but one that deserves to get out nonetheless. The fact is that any advisor not using options may be missing out on opportunities every day—especially in these times of geopolitical tail risk, whipsaw markets and zero-interest-rate-policy-era bond yields.

The three best reasons to incorporate exchange-listed options into an investment portfolio are:

  1. Flexibility
  2. Yield boosting
  3. Intelligent hedging

Options are uniquely flexible financial instruments that, by their very nature, avoid the most obvious defining limitation of an underlying security such as an ETF. Namely, any time investors want to gain upside exposure through an ETF, they must simultaneously accept a risk of loss if the ETF's price drops. For example, if investors hope to gain from exposure to the energy sector, they must simultaneously accept the risk that energy may fall. Figure 1 shows the simultaneous gain of exposure and acceptance of risk.

Figure 1. Risk/return diagram for purchaser of 100 shares of an ETF. The gold region represents the range in which investors will gain from price appreciation; the gray region represents the range in which investors must accept downside price risk. Note that when purchasing an ETF (or stock), the potential for capital gains goes hand in hand with the potential for capital losses and cannot be separated.

This risk/return trade-off is so natural it is considered matter-of-fact. However, the great beauty of options as financial tools is that they allow an investor to control risk by mitigating the magnitude of their directional exposure.

In other words, with options, you can gain exposure to an ETF while effectively hedging (or managing) the security's price risk. Or, you can choose to accept exposure to an ETF's price risk in exchange for a monetary payment even if you don't want to gain exposure to the ETF's assets (see Figures 2 and 3).

Figure 2. Risk/return diagram for purchaser of one contract of a call option on an ETF. Note that the price at which the range of exposure begins—called the "strike price"—can be chosen by investors, as can the date on which the option expires. These features highlight the great flexibility of options.

Figure 3. Risk/return diagram for purchaser of one contract of a put option on an ETF. The put option is flexible in the same way the call option is, but allows investors to gain if the price of the ETF drops, while not accepting the risk of a price move to the upside.

Using options in conjunction with a securities position leads to the other two great reasons to use options—yield boosting, and hedging.

Yield Boosting
What kind of yield would you expect to get from a corporate bond rated Aaa? Maybe 4% a year? The post-crisis low-yield environment means a lot of retired clients are having to liquidate holdings to fulfill IRS rules defining the amount of money that must be withdrawn every year simply because high-quality bond yields are so low.

Imagine the possibility of being able to create a portfolio of "quasi bonds" on companies rated Aaa that have the ability to generate 4% per quarter rather than 4% per year. This is the potential power of the options strategy of selling put options (and of the risk-equivalent cousin strategy of selling "covered calls").

The essence of selling or "writing" put options is similar to that of an insurance company underwriting a policy on your home or car. An insurance company receives a fee (a premium) for accepting the risk of loss if the value of your insured asset drops below a certain value.

Similarly, an investor who writes a put option accepts the risk of loss if a stock or ETF falls below a certain price (the "strike price" mentioned in Figure 3) and in return, receives a cash payment—also called a premium. You'll sometimes hear the phrase "cash-secured put" in this case. "Cash secured" simply means the investor selling the put option places cash collateral equal to the value of the stock in a margin account for the life of the option.

Some investors may worry about accepting downside risk, but you can see from Figure 4A that investors selling cash-secured puts reduces risk compared with investors buying an asset outright.

We can see in Figure 4B that both investors accept the risk of the asset's price falling, but only the option investor receives a cash premium for doing so, and accepts risk for only a limited duration. The investor in the underlying receives only hope for a move higher in the underlying while accepting immediate downside risk.

Figures 4A & 4B. Risk/reward exposures for holders of an energy sector ETF (left) and for sellers of a short-duration put option on the same security.

Imagine you have clients who worked for years for XYZ company. A good chunk—too large of a chunk—of their assets are tied up in years' worth of XYZ capital gains. This is a problem all advisors have run into at one time or another: what to do with concentrated holdings.

There are a number of reasons why hedging a concentrated position by buying a put option—owning the right to sell the stock at a set price—may not be the best way to go; not the least of these is price. While investors may potentially enjoy making 4% a quarter in premiums when selling options (see Yield Boosting, above), paying 4% per quarter buying them is a lot harder to enjoy.

There is a simple and effective way to subsidize downside put protection while increasing potential diversification away from the concentrated position. This strategy has the nickname of a "collar," and is made up of two simple components: a covered call, with the simultaneous purchase of a protective put (Figure 5).

Figure 5. The risk/reward position of the option strategy is known as a collar. The gold area in the top of the diagram represents the neutralization of upside price potential from the sale of a call option. The darker gray area in the bottom of the diagram represents the neutralization of downside price risk from the purchase of a put option.

If the stock price rises above the strike price of the covered call, the holder of the concentrated position may be required to deliver (sell) shares at the strike price.  This has the effect of naturally decreasing investors' positions in the concentrated holding and giving them cash to use to diversify.

Conversely, if the stock price falls, investors can recoup at least part of their stock losses thanks to the gains from the holding of the put option. Again, if the investor exercises their put option, they will be delivering (selling) shares at the strike price and will receive cash in hand to diversify away from the concentrated holding, and the concentration of the holding is also reduced.

Collars can be crafted such that the price of the protective put is partially or completely subsidized by the cash received from the covered call. Depending on how much upside you're willing to forgo, you may be able to construct a collar at low or sometimes no cost.

Disclaimer: Options involve risk and are not suitable for all investors. Individuals should not enter into options transactions until they have read and understood the risk disclosure document characteristics and risks of standardized options available by visiting www.optionseducation.org.

Any strategies discussed, including examples using actual securities and price data, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation or solicitation to buy or sell securities. Past performance is not a guarantee of future results. Copyright © 2016 The Options Industry Council. All rights reserved.



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