Options-Based ETFs: For When All is Not Well

Options might be the most misunderstood aspect of investing today. 

On the one hand, we have so-called “zero days to expiration” options, and the speculators that traffic in them. I say speculators and not investors, since these options contracts have about the same lifespan as a mayflies. What is a mayfly? An insect that has a lifespan of about 24 hours. Yes, I had to look that up.

That is one end of the options market. The other is so-called LEAPS, in which an investor can take a position using an options contract, thereby laying out less money than it would cost to own or short a stock or ETF but knowing that the contract only has value at its expiration date if the security’s value exceeds its “strike price” on that date. In between, plenty of things can happen.  

In between are options that expire every week, month or quarter, depending on the security. And at a time when markets are quite content, judging by the VIX closing at just the 13 level on Monday, financial advisors and investors who have studied the characteristics and risks of options may just have a great extra tool in their toolbox.  

ETFs That Say “Hand Me My Gap Wedge”

Or, to use a golf analogy, most players carry in their bag a sand wedge designed to lift the ball out of the sand (though some opt for a “hand wedge” if they prefer not to attempt that shot, if you know what I mean). And they carry a pitching wedge for shots that are close to the green but far enough away so that they need the ball to carry a bit further in the air.

But other players will also carry a gap wedge, which as the name implies, is used for shots that are a bit too short for a pitching wedge, but where the ball is not in the sand. The modern investor’s equivalent? ETFs that use options as a central part of their strategy.

There is a wide variety of such funds, but a subset of them might be particularly relevant to some investors and advisors, depending on whether they seek to profit from a continued market rise with a limited capital outlay, or if their priority is to try to hedge against a steep drop in the market. In particular, declines that occur very quickly, such that trying to position for it once it starts might already be too late. This was the case for some investors in early 2020 when the pandemic first struck, and the S&P 500 gapped down (nothing to do with gap wedge), in a week, stabilized for just days, then the bottom really fell out. Net damage: 33% down in just five weeks.

That was a fine time to own ETFs that use exposure to the VIX volatility indicator as a surrogate for committing larger amounts of capital to equities or equity ETFs. VIX typically rises when the S&P 500 falls, and VIX drops when the S&P 500 rises. That is, higher VIX mean higher volatility, and volatility is a classic Wall Street code word for “stocks are losing value.”

Volatility ETFs: a Sampler

There are several options-based ETFs and the list is expanding rapidly, so investors absolutely need to do more research than usual here. These ETFs are extremely volatile themselves, and that’s why they are often used in very small quantities, to create what is essentially a leveraged substitute for buying a stock index ETF or shorting them via an inverse stock index ETF.

For example, a pair of ETFs with just north of $300 million in assets represent opposite takes on the VIX. The IPath Series B S&P 500 VIX Short Term Futures ETN (VXX) accesses volatility’s path via futures contracts on the CBOE Volatility Index with average one-month maturity. Exposure resets daily.

And the ProShares Short VIX Short-Term Futures ETF (SVXY) provides inverse exposure to an index comprising VIX future positions expiring in one month and two months into the future. SVXY offers daily -0.5x exposure to short-term VIX futures in a structure referred to as a commodity pool.  

Note that these are tactical tools designed for short-term exposure, and some prompt K-1 tax reporting if held. Again, these two are merely an introduction to the existence of ETFs that allow investors to commit a smaller amount of money to get something that may resemble stock market exposure (long or short). At a time when T-bills still yield over 5%, the concept of having, for instance, an ETF like SVXY that may go up a lot in value if the S&P 500 does, but could lost much of its value quickly in a down market, is a tradeoff that might be a consideration for some investors. That is, unless the investor happens to be a mayfly.

Options-based ETFs tor a complacent market. Put/call ratio curiously low, so is VIX, while Wall Street pundits parade their bullish views to a mass audience. A bit of historical perspective, and some ETFs to play it in either direction.