[This article appeared in our February issue of ETF Report.]
Investors are often surprised by the breadth of the ETF options universe.
Frank Tirado is vice president of education for the Options Industry Council (OIC). ETF Report sat down with him to talk about the well-populated landscape for ETF options and how investors can use them.
What kind of exchange-traded products are typically the subject of options? Which ones typically get their own options?
What’s interesting is that most investors and advisors, obviously, are familiar with the number of stocks trading and have a sense of the number of the ETFs, and the number of the index options out there. But as general knowledge, very few really know there are over 600 different optionable ETFs and exchange-traded notes, meaning exchange-traded products (ETPs). That’s a great body of ETPs that investors and advisors can use.
When you look at ETPs, you’re looking at three major categories. Category one is major indexes—the S&P 500, the Nasdaq indexes, the Russell 2000, etc.— those are the usual suspects that most investors and advisors are fully aware of.
The second category has to do with more volatility products. You have a lot of products that are connected to the volatility indices. And the third is emerging markets, or country or different sector ETFs. So those kind of encompass most of what ETF options are traded on.
When you look at what investors want, you have the very conservative, risk-averse investors, and you have the more aggressive investors who are looking for a bit more yield.
With very low interest rates still, we’re living in a world that’s very uncertain. Political uncertainty and political risk have basically taken position No. 1 now, because of what we’re seeing in politics, not only in the U.S. but around the world. And that uncertainty can be hedged with options.
What’s the typical way to do that?
We all know about the Great Recession in 2008 and ’09 and ’10, and how it created just a tremendous amount of fear and pain and agony. The market has rebounded, and really has given us a lot since the valley of 2009.
And so investors are now looking at that and asking, “How can I protect this return? How can I protect the gains that I’ve received so far?” And that’s where options come in. And there are multiple strategies.
The protective put is the most expensive but the easiest to do. Basically, you’re buying an insurance policy on the underlying ETP. So that insurance policy will cost you and will be expensive based upon how much insurance you’re willing to buy. For example, some investors will say, “Protect every single penny in my portfolio.” And that attitude will cost that investor more money than, say, the investor who says, “You know what? I want to hedge maybe 50% of my portfolio, 40% or 60% of my portfolio.” Then the insurance costs will be less for that individual.
But the protective put is probably the easiest way to go. You have to decide on three basic questions. One, how much of my portfolio do I want to protect, 100%, 50%, 40%, etc? No. 2, how much downside can I live with? If the answer is no downside, I want to be fully protected at the current levels of the index underlying that ETF, then [that can be] expensive.
But some individuals will say, “You know what? I’ve been holding on to the SPY for the last 10 years. It’s reaching the 300% return since the valley. I’m willing to give up maybe 10% of the downside, 5% of the downside or more.” And that insurance policy, because it has kind of a deductible built in it, you’re willing to take some downside. That’ll be cheaper.
Then the last question is, “How much time do I need?” And again, time is money, and therefore, the longer the insurance policy into the future, the more you can expect to pay for it, in the same way you would a home insurance policy or car insurance policy or life insurance policy. The longer the term, the more expensive that’ll be.
These option strategies on your equity exposure seem like a very complex thing for the average investor to do. Is this an area where advisors can add value in the era of do-it-yourself investing?
Absolutely. Almost all investors are fully aware of the concept because it’s an insurance concept, right? We’re talking about options as a form of protection. The idea is there—they know they can protect or hedge their home, protect or hedge their car, protect or hedge their life. Once they hear they can hedge and protect their portfolio, the first question that comes up is, who’s taking the other side? Who’s crazy enough to sell insurance on the market?
And that’s where the market makers come in. That’s where our options exchanges come in. That’s where the option industry infrastructure comes in to provide that insurance. This is nothing new. Optionality is everywhere.
It’s not calling your insurance agent, getting a quote, etc. But it’s those same questions you have to ask yourself. “Put options” is what we call our insurance policies in the option world. Put options can be bought or sold with a broker. And getting to your question regarding advisors, it’s absolutely a point of differentiation, absolutely a point of value. Advisors today are being attacked regarding what value they bring to the table in the robo advisor world.
If they can frame themselves in the context of being a risk manager such that they can construct solutions that’ll protect clients’ wealth, people will not be shy to pay for that. Because, yes, I want to build my wealth, on the one hand. On the other hand, I certainly don’t want to lose it. If I were a client, talking to an advisor wanting to get my business, I would ask a question: “We came out of 2009 with this Great Recession. What kind of solutions can you provide to avoid that?” That would be my key question.
Options are a differentiator. Advisors should be aware of options solutions. The OIC collaborated with the Investments & Wealth Institute to create the Fundamentals of Exchange-Listed Options course, specifically designed for advisors who want to learn more and build their confidence with options.
So because options strategies are a way to blunt volatility and protect your investment, you’re going to see more volume in contracts on the more volatile products, right?
Your instincts are right. When people have wealth attached to a market that’s moving, they’re either risk averse or attracted to that movement. And options are unique in that you can build strategies that’ll benefit from that. If you’re defense-minded and a bit more risk averse, then you can construct strategies like the protective put, the protective put spread, the protective collar. Those are three very fundamental and basic strategies that investors can build playing defense.
You can use options, to your point, covered-call writing, to generate income. There’s another great strategy called cash-secured put writing, which is a wonderful way to generate income. But also, it’s a wonderful way to build an ETF position.
Let me explain how that works. Most investors and advisors are familiar with the concept of dollar cost averaging. It’s a basic system that’s been developed years ago to set aside some money and buy X-amount of dollars of the asset over time. So you have an average price versus being all in at once.
And so with cash-secured put writing, it’s interesting. You sell a put. And when you sell a put, you collect a premium. But that premium, also, the sale of a put obligates you to buy the underlying ETF [should you be assigned]. And so you’re basically being paid to buy the ETF. So, cash-secured put selling or cash-secured put writing is a way that investors will, in essence, dollar cost average into a position while collecting the premium of the option.