More Options With More Options

October 29, 2012

More options With More Options

Exchange-traded products span a wide range of offerings, including broad style, sector, industry, country, regional and cross-asset benchmarks. A key reason for their popularity is convenience. Because exchange-traded products trade and settle like a stock, there is no additional infrastructure or documentation required. The most popular exchange-traded product is the exchange-traded fund. For the remainder of this piece, for readability and familiarity, we use the term “ETF” to mean exchange-traded fund and to include other exchange-traded products such as exchange-traded notes (ETNs).

Since the credit crisis, with cross-asset correlations rising, there has been increased demand for investments with broader access. As a result, hedge funds and traditional institutional investors increasingly are using ETFs. Common applications include allocating assets, top-down investing, cash flow management, hedging either broadly or tactically within sectors and executing relative value strategies; for example, trading a stock versus its own sector. ETFs offer flexibility, and given that the products trade like ordinary equities, some institutions that are restricted from using traditional derivatives are able to use ETFs.

Along with growth in the ETF market, there has been a similar rise in the use of options on exchange-traded products. The goal of this report is to examine the size, growth and breadth of the ETF options market and then provide examples of options strategies this market now allows. The analysis that follows uses a universe of ETF options whose underlying ETF country of domicile is the United States and that which is traded in U.S. dollars. We exclude ETFs for which the median daily notional option volume to date (Sept. 7) as of 3Q12 is not at least $10 million. The ETFs with options that meet these criteria are in Figure 1, with their respective third-quarter 2012 (to-date) median daily notional volume.

The ETF options market has been growing through the last decade, with offerings now available across a wide range of equity, commodity, fixed-income and currency ETFs. Consequentially, a liquid and broad ETF options market now allows for options strategies such as cross-asset hedging, overwriting or relative value—traditionally placed at the single-stock and index level within equities—to now be applied at a style, sector, industry, country, regional or cross-asset level.

The remainder of this piece is in two parts. We survey the market of options on exchange-traded products, examining the market size, growth and depth. Then, we list and explain examples of strategies that the options market on exchange-traded products now allows.

Market Size, Growth And Breadth
Market Size And Growth
Over the last year, the total notional traded on ETF options has ranged from approximately $40 billion to $50 billion per day (Figure 2). For perspective, listed S&P 500 index notional option volume ranged from about $80 billion to $95 billion (the largest of all equity indexes globally) per day for the same period.1 Notably, approximately 85 percent of the total ETF options volume is traded among only four ETFs. These top four most-liquid ETF options are on SPY (S&P 500), IWM (Russell 2000), QQQ (Nasdaq 100) and GLD (gold). ETF options on SPY grew considerably from 2007 to 2011, and currently trade with one-third of the volume of S&P 500 index options. ETF option volume peaked in the third quarter of 2011 at approximately $66 billion in notional per day. ETF options volumes, like those across other asset classes, have been declining over the last year, as markets appear exhausted from ongoing and lengthy global macroeconomic concerns.

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