ETF Options Provide Flexible Tools for Hedging, Managing Risk

June 10, 2004

The proliferation of ETF options has provided investors with new tools covering narrower areas of domestic and international markets.

The growing range and liquidity of ETF options are allowing financial advisors and individual investors to implement strategies previously available only to large sophisticated institutional investors.

In April there were 68 options and 7 'single stock futures' futures on ETFs trading in the U.S., Europe, and Canada - according to a report by Morgan Stanley. There are 56 options on ETFs in the U.S., covering about 40% of all ETFs.

The Nasdaq 100 (ticker: QQQ) option is the most actively traded option with a volume of 31.8 million contracts in the first quarter of 2004. The QQQ option accounts for 86% of all US listed ETF option contract volume, according to Morgan Stanley.

The proliferation of ETF options has provided investors with new tools covering narrower areas of domestic and international markets.

 

Top 10 U.S.-Listed ETFs by % Change in Options Trading Volume (Quarter on Quarter)

ETF
Ticker
Q3 2004 Volume
Q1 2004 Volume
Quarter on quarter change (%)
iShares Russell 3000 Value
IWW
79
1,327
1579.7%
iShares Russell MidCap Value
IWS
363
2,788
668.0%
Energy Select Sector SPDR
XLE
20,983
101,773
385.0%
Fidelity Nasdaq Composite Index Tracking Stock
ONEQ
13,400
63,116
371.0%
iShares Lehman 1-3 Year Treasury Bond Fund
SHY
1,804
7,104
293.8%
iShares Goldman Sachs Networking
IGN
2,718
10,073
270.6%
iShares DJ US Utilities Sector
IDU
1,366
5,020
267.5%
Consumer Staples Select Sector SPDR
XLP
3,057
8,064
163.8%
iShares S&P SmallCap 600/Barra Growth
IJT
1,299
3,156
143.0%
iShares Cohen & Steers Realty Majors
ICF
3,415
8,285
142.6%

Source: CBOE

"Options on ETFs offer strategies for managing the risk or expanding opportunities for profit," said Deborah Fuhr, head of ETF research at Morgan Stanley. "Because ETFs are traded like stocks, ETF options are very similar to stock options. Just as stock options settle in shares of stock, ETF options settle in ETFs."

The minimum trading size is one option contract: in notional terms each contract equals 100 multiplied by the ETF value. One option contract represents 100 underlying ETFs. The value of the ETF futures and options are 1/100 of the index. They are physically delivered rather than cash settled, explained Fuhr.

Options and single stock futures on ETFs have growth potential because of the liquidity the underlying ETFs provide.

The number of stock index futures has been relatively small, because of the need to concentrate liquidity for futures. "But for ETF derivatives, the 'solid leg' of liquidity is derived from the underlying ETF, which in turn is dependent on the liquidity of the constituent stocks, and less dependent on ETF trading volume," wrote Steven Schoenfeld in the last chapter of his upcoming book, Active Index Investing.

This means that derivative structures can be created on a virtually limitless range of underlying ETFs.

For example, ETF options have been launched on the small-cap S&P 600 ETF and the iShares fund tracking the international MSCI EAFE index. There are ETF options trading on the CBOE, International Securities Exchange (ISE), and American Stock Exchange. Additionally, OneChicago and NQLX have also entered the market. (For more on the future of ETF options and how to use them, see Chapter 31 of Steven's Schoenfeld's upcoming book Active Index Investing)

ETF options as conservative hedges

There are two types of ETF options: calls and puts.

"A call option gives the holder the right to buy 100 shares of the underlying security at the strike price, at any time prior to the options expiration date. The writer or seller of the option has the obligation to sell the shares," Fuhr said.

A put option is the opposite of a call option, giving the holder the right to sell 100 shares of the underlying security at the strike price, at any time prior to the options expiration date. The writer or seller of the option has the obligation to buy the shares.

For example, conservative investors who own an ETF that has appreciated significantly can sell calls to protect against a minor correction, and receive income if the market goes sideways. However, covered calls limit upside potential if the ETF jumps higher, and they don't protect against steep market declines.

On the other hand, buying puts on an already-held ETF providers more insurance against more serious market downturns.

Investors need to consider transaction costs and if simply selling an ETF, rather than using options, and taking a capital gains tax hit might be a cheaper way to protect against potential loss.

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