Options, Futures & ETFs, Oh My!

February 06, 2018

[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.

Options-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.”

ETF Options Vs. ETFs
Options are now available on more than 600 ETFs. But one important thing to remember about ETF options is that the size and liquidity of a given fund is no indicator of how large or small its options market will be. In fact, some smaller ETFs have vibrant options markets, while some of the largest ETFs have anemic ones.

Figure 1 includes 2017’s top 10 largest ETF options contracts of 2017 on Cboe, the largest U.S. options exchange.


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By volume, the top two ETF options markets in 2017 were for options on the SPDR S&P 500 ETF Trust (SPY) and the PowerShares QQQ Trust (QQQ), which are the largest and eighth-largest ETFs, respectively.

But the iPath S&P 500 VIX Short-Term Futures ETN (VXX), whose options had the fourth-largest trading volume in 2017, doesn’t even crack the top 100 exchange-traded products in terms of assets under management. Neither does the ProShares Ultra VIX Short-Term Futures ETF (UVXY) or the SPDR Oil & Gas Exploration & Production ETF (XOP).

Meanwhile, the second- and third-largest ETFs, the iShares Core S&P 500 ETF (IVV) and the Vanguard Total Stock Market ETF (VTI) had only middling volume in their ETF options, coming in at the 153rd- and 113th-largest markets, respectively.

In fact, it’s best to think of ETF options liquidity like ETF liquidity: When placing a trade, what matters isn’t just the liquidity of the underlying or just the liquidity of the ETF, but both at once.

“If you’re trading options on ETFs, one should look at both the volume of the option and the volume of the underlying. Ideally, you’ll have a decent amount of both,” said Moran.

Futures-Based ETFs
Once a novelty, futures-based ETFs are now commonplace. Futures are held by everything from commodity and currency funds to volatility products and leveraged and inverse funds, even many alternatives ETFs.

For good reason, too: Like with options, investing in futures-based ETFs is usually much cheaper and easier than investing in individual futures directly, where margin requirements alone can run investors tens, even hundreds of thousands of dollars.

“Futures-based ETFs open up markets that were once much more difficult to access,” said Kevin Davitt, senior instructor for Cboe’s Options Institute.

How Futures-Based ETFs Work
Futures-based ETFs come in many shapes and sizes. Some go all in on the front-month contract for a single asset, while others hold a broad basket of contracts across expirations or assets. Some algorithmically select contracts to optimize costs or momentum, and others use factors and alternative weighting schemes to diversify their exposure.

Most futures-based ETFs, however, go long some particular contract or set of contracts. To do so, the fund manager must “roll” the ETF’s futures, meaning they must sell expiring contracts and move into the next appropriate ones. This incurs some cost or profit, known as the “roll yield.”

If nearer-term contracts are more expensive than longer-dated ones (meaning, roll yield is positive), then that futures market is said to be in “backwardation.” If, however, nearer-term contracts are less expensive than longer-dated ones (meaning, roll yield is negative), then the market is in “contango.”

Essentially, markets in contango are ones where investors expect higher prices tomorrow than they see today; energy markets, like crude oil, are particularly contango-prone. Markets in backwardation, however, are ones where investors expect falling prices on the horizon. Many agricultural commodities, for example, move in and out of backwardation according to seasonal fluctuations in demand.

How To Mitigate Contango
Though little can mitigate unfavorable moves in a future’s spot price, what an ETF holds can have significant impact on its roll costs. 

A front-month-only futures ETF, like the United States Oil Fund LP (USO), offers the closest possible exposure to spot prices, but it’s also most exposed to the ill effects of negative roll yield, since it needs to roll contracts more frequently. If contango is persistent, it can erode gains from beneficial spot price moves.

ETF issuers have come up with two main alternatives to mitigate persistent contango. The first is to select futures contracts across some number of expiration dates. This somewhat minimizes roll cost, because the ETF is only ever rolling some fraction of its total portfolio at a time. The WisdomTree Continuous Commodity Index Fund (GCC), for example, does just this, holding contracts across the nearest six months in an equal-weighted basket. 

The problem is, the longer-term the contracts, the more prices will deviate from spot. Also, since longer-dated contracts tend to have less volatility, there will subsequently be less volatility premium to capture.

The other solution is to use an algorithm or rules-based process that selects contracts for optimal exposure, such as selecting the next contract by whichever one has the most favorable roll yield. Many commodity ETFs now take this approach, including the PowerShares DB Commodity Index Tracking Fund (DBC) and the United States Commodity Index Fund (USCI). This approach too can diversify the ETF’s exposure away from spot and sacrifice volatility premium, however.

“The moral is,” said Davitt, “know what your ETF holds.”

How Options Work
Options are unique contracts that give the buyer the ability—but not the obligation—to purchase or sell an underlying security at some predetermined date and price (the “strike price”). There’s no such flexibility on the short side, however: Should the buyer decide to exercise their option, then the option seller must complete the transaction (i.e., sell to a buyer or buy from a seller).

Like futures, options contracts are standardized and trade on specialized exchanges. Typically, in the case of stock or ETF options, contracts are written for 100 shares of the underlying; but for other assets, such as commodities or currencies, contract sizes can vary widely.

A “call” option gives its owner the ability (but again, not the obligation) to purchase the underlying security at the strike price, while a “put” option gives its owner the ability to sell.

Essentially, options allow investors to express their view on the future price direction of some asset, without having to own the asset itself. That opens up a bevy of sophisticated strategies that allow investors to hedge risks, protect profits and generate income no
matter how the market is moving—if it’s moving at all.

“Generally, options provide more nuanced exposure than futures,” said Kevin Davitt, senior instructor for Cboe’s Options Institute. “They’re subject to dynamics that are less price sensitive, such as volatility. Volatility can be a very good thing if you own options, but a very bad thing if you’re short.”

How Futures Work
In a futures contract, a buyer and a seller agree to exchange a set quantity of some underlying asset at some predetermined date and price. Unlike options—which give buyers the choice of whether to exercise—a futures contract must be fulfilled when it expires, with both buyers and sellers holding up their end of the transaction.

Futures are all about the future. “They’re a purer play on directional price moves,” said Davitt. “If a future moves up from where you bought it, you make money. If it moves down, you lose money.”

Futures can be written for any number of assets or securities: commodities, currencies, interest rates, indexes, even alternative assets like volatility or real estate. The contracts trade on specialized exchanges and are standardized for quantity, expiration date, and delivery time and location.

Because they’re forward-looking, futures are invaluable for hedgers like commodity producers and users, commercial enterprises that buy or sell overseas, and other entities that might need to protect against unfavorable price moves at some future date.

But speculators flock to futures as well, using them to access corners of the market that for logistical reasons might otherwise be off limits. Speculators play an important role in the futures market by providing the liquidity that allows hedgers to offset their price risks.


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