[This article appeared in our February issue of ETF Report.]
Derivatives aren’t just for institutions anymore.
Today investors of all sizes and sophistication levels can use options- and futures-based ETFs to hedge risk, generate income and access asset classes and strategies that were once out of reach. Increasingly, investors are turning to options on ETFs, too—even options on options ETFs.
“Textbooks say [derivatives] are just for sophisticated investors, but they’re really for anybody who knows the return stream they’re looking for and how to express it,” said Mike Venuto, CIO and co-founder of Toroso Investments. “The potential strategies are limitless.”
Of course, derivatives, even those in an ETF wrapper, still come with a steep learning curve, as well as unique and significant risks that don’t exist when trading vanilla stocks and ETFs.
That’s why we’ve put together this guide, so you can understand the risks and rewards specific to options-based ETFs, ETF options and futures-based ETFs.
Though options-based ETFs have increased in number in recent years, it’s still difficult to ascertain exactly how many ETFs use them in their baskets.
Pure-play options ETFs remain rare: For example, there are only eight ETFs that implement covered calls, a common options strategy where an investor buys securities and then sells calls on them. (A ninth, the WisdomTree CBOE S&P 500 PutWrite Strategy Fund (PUTW), is often lumped in with these funds, though it technically isn’t a covered-call ETF.)
Other ETFs, however, use options as a seasoning to the sauce, overlaying calls and puts to complement their other holdings.
The Cambria Core Equity ETF (CCOR), for example, primarily holds dividend-paying large-caps, upon which it overlays an options collar strategy. (An options collar is a combination of a covered call and a protective put to help limit downside risk.) The First Trust Hedged BuyWrite Income ETF (FTLB), meanwhile, is an active portfolio of U.S. large-caps that also overlays short calls and long puts on the S&P 500 Index.
Why Use An ETF?
Although ETFs that use options remain a fairly niche product, 2017’s strong inflows suggest that investors are becoming increasingly enamored with them.
A handful of options funds in particular saw strong inflows last year: PUTW, CCOR and the Horizons Nasdaq-100 Covered Call ETF (QYLD), which saw new net assets of $264 million, $117 million and $107 million, respectively.
It’s easy to see why investors like these ETFs, given current market conditions. Options strategies offer investors, obviously, options: Investors frustrated by low bond yields can use covered calls to eke out income, while investors wary of the frothy bull market can use put-write strategies to protect against downside risk.
“If you want to go above and beyond what stocks can do, options are the next step,” said Matt Moran, VP of business development for the Chicago Board Options Exchange, the largest U.S. options exchange. (The Chicago Board Options Exchange and ETF Report are both owned by Cboe Global Markets.)
Yet using options directly is difficult for many investors. Contracts expire frequently and need constant resetting, making for a logistical heavy lift. Trading costs can rack up, especially without the benefit of scale. Thus, packaging options into an ETF makes them easier and cheaper for investors to implement, as well as more tax efficient than individual contracts.
At Toroso, Venuto uses many options ETFs, including PUTW and the Credit Suisse X-Links Gold Shares Covered Call ETN (GLDI), an exchange-traded note that replicates the returns of a covered-call strategy using shares of the SPDR Gold Trust (GLD) and one-month call options with a strike price 103% that of GLD.
“One of the biggest threats to an income strategy is inflation, and one of the biggest hedges to inflation is gold,” said Venuto. “So if I can have gold in my portfolio that produces income, that’s a holy grail.”
Downsides Of Options ETFs
Options ETFs aren’t without their drawbacks, however—not the least of which is often anemic performance. Though covered calls and put-write strategies outperform in declining and sideways markets, they underperform in a raging bull market, such as the one we’ve seen for the past several years.
“There’s no such thing as a perfect strategy,” said Moran. “Covered calls can generate very attractive income with very low interest rates, but you’re also giving up some upside potential with the underlying stock—especially if that stock doubles or triples in a matter of two or three months.”
Options On ETFs
Options on ETFs function just like other kinds of options (see sidebar), except that the underlying in this case is an ETF, rather than a stock or index.
ETF option contracts tend to be small in size (roughly 100 shares), with physical delivery and the built-in ability to exercise early. Typically, they cost less than an equivalent number of ETF shares, though returns in dollar terms tend to be smaller as well. That attracts a larger retail audience, says Moran.
“Index options are more for big institutions,” he said, “whereas, because of the smaller size, more individuals and advisors use ETF options.”
Why ETF Options?
ETF options can serve a range of portfolio functions, including:
- Hedging unfavorable price moves
- Generating income amid persistent low yields
- Minimizing—or exploiting—the impact of market volatility
- Speculating on future price movements
“When applied to an ETF, an option changes the potential outcomes,” said Venuto. “An ETF can go up, down or stay flat. That’s pretty much it. But with ETF options, suddenly you can create income using a buy-write strategy, or you can use a collar to make the return stream more certain.”
ETF options can also be used to gain leverage on the underlying, allowing investors to express a viewpoint on the direction of a given ETF or sector without needing to buy or sell securities (and possibly take on a subsequent tax hit). “I can commit much less capital to express an opinion,” said Venuto. “The trade-off, though, is that I have to be right not just on direction but on timing.”
However, ETF options carry the same risks as any other options contract. For example, an investor’s potential profit usually is constrained by the strike price and the premium received, but, depending on the particular strategy, potential losses can be unlimited.
“Options are like electricity,” said Moran. “If used improperly, they can be dangerous. But if used properly, they are incredibly powerful tools.”