Protecting Bond ETF Profit With Options

January 29, 2015

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. Almost 136 million options on ETFs were traded in December 2014, and because ETFs and options are among the fastest-growing financial vehicles in the world, it only makes sense to combine the two. This column highlights unusually large or interesting ETF options trades to help readers understand where traders believe a particular ETF may be headed. In doing so, Nations will examine the underlying options strategy.

 

Long-term investors in ETFs love to look at options—particularly put options that give the owner of the option the right, but not the obligation, to sell her shares at a particular price as insurance.

 

If the ETF is below the strike price of the option at option expiration, then she’ll sell her shares and recoup at least some of her losses.

 

But options can be expensive. Your homeowners insurance is affordable because it’s pretty unlikely that you’ll experience a house fire. But it’s much more likely that your ETF will drop in value by 20 percent, so insurance on your ETF is much more expensive than insurance on your house.

 

How expensive are these options?

 

If you wanted to insure your shares of the SPDR S&P 500 ETF (SPY | A-98) against any loss for the next 12 months, it would cost you about 7.1 percent of the value of your shares. And what has SPY returned since it was created in 1993? It has an average annual return of 11.1 percent, including dividends, so your insurance would have eaten up nearly two-thirds of your return.

 

And options on fixed-income ETFs aren’t any less expensive than SPY options. For example, options on the iShares 20+ Year Treasury Bond ETF (TLT | A-85) that protect against any loss would cost about 7.7 percent of your investment. And since TLT was introduced, its average annual return has been 8.5 percent. Protective options would consume nearly all of your returns in TLT.

 

But TLT is on a terrific run, as you can see, and prudent owners are thinking about protecting some gains:

 

 

Option hedgers in TLT could just buy puts, but we’ve seen that options are fairly expensive. However, they can use that cost to their advantage and pay for their protective put by simultaneously selling a covered call in TLT. This combination of long TLT, long a protective put, and short a covered call is called a “collar” because it creates a range of effective prices for our shares of TLT at option expiration.

 

For example, with TLT at $134.85 recently, a hedger could pay $2.20 for the April $130 strike put. That put would protect against any loss below the breakeven point of $127.80, but there are some problems with just buying a put.

 

First, the $2.20 per share cost is equal to about 1.6 percent of the value of the shares. Second, it only offers protection until April. Finally, the protection doesn’t kick in until TLT has dropped to $127.80.

 

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