This is a weekly column focusing on ETF options by Scott Nations, a proprietary trader and financial engineer with about 20 years of experience in options.
Savvy ETF investors like to use options because there are so many different strategies that express the same general market outlook. One strategy might collect premium, one might cost premium and one might be done for no net premium, meaning an investor can tailor her strategy for her specific market outlook rather than just using the blunt instrument of buying or shorting the ETF.
For example, a bullish investor might buy a call option that will cost premium, or she might sell a put option that will generate premium, or she might combine the two in a third structure that doesn’t pay or generate much premium, but that will have a unique payoff profile.
3 Options Plays On Spy
An investor who is bullish on the SPDR S&P 500 ETF (SPY | A-99) could simply buy a call option and get bullish exposure. Unfortunately, that requires paying premium. However, that premium would be our maximum potential loss, while the potential profit is theoretically unlimited; as long as SPY continues to rally, our call purchase will continue to increase in profit.
With SPY at $199.72 recently, an investor could have bought the November $201 strike call for $4.85 per share. This call option would give the call owner the right to buy 100 shares of SPY at $201.00 at any time prior to option expiration. While the premium paid is the maximum potential loss, the downside of this trade is that SPY must rally for the trade to be profitable, as you can see:
Selling A SPY Put Option
As an alternative, a bullish investor could also sell a put option in SPY to get bullish-to-sideways exposure.
Selling a put option generates option premium that the put seller gets to pocket, no matter how low SPY goes. If SPY drops below the strike price of the put option at expiration, our put seller will end up buying the stock at the strike price, although the premium received will lower the effective purchase price of the shares; selling a put option is a little like a limit order to buy the shares.
Since this is the case, the potential loss is similar to that from owning the shares—as you can see from this example, again, with SPY at $199.72, but in this case, selling the November $195 strike put option at $4.90. The breakeven has now been lowered to just $190.10. Above there, this trade is profitable, but the profit is limited to just the $4.90 in premium collected.
Risk Reversal Option
A third strategy for a bullish investor is to combine those two strategies such that the put option sold pays for the call option purchased. The trade is generally done for little or no net premium and is called a risk reversal.
If SPY is below the strike price of the put option, our investor will end up buying it at that strike price, $195, in our example. If SPY is above the strike price of the call option, then our investor will end up buying it at that strike price, $201.
By combining the two trades above—a call purchase and a put sale—the investor would collect $0.05, and would get long below $195 or above $201, as you can see. If SPY is between those strike prices at option expiration, then both options expire worthless, and our trader could re-evaluate and potentially execute a similar trade again.
That’s three different ways to get long SPY using options, each with a unique risk/reward profile and premium flow. And they allow an investor to tailor their trade for their outlook, from mildly bullish (maybe sell the put option) to very bullish (maybe buy the call option).
This ability to express similar market outlooks with different strategies is what makes options so valuable to every ETF investor.
At the time of writing, the author held a long position in SPY and a delta neutral option position in SPY. Follow Scott on Twitter @ScottNations.