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.

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