Looking At All The ETF Options

Unusual market events have a way of sticking in our memories, especially when they produce drawdowns that leave even the savviest advisor wondering how to explain to their clients what happened.

The volatility spike of early 2018 might not have decimated most accounts, but it did provide an unpleasant jolt for many ETF investors and their account managers.

At some point, we'll get another one of these dispiriting moments. As the years go by, maybe we'll get a lot of them. Although that's not to suggest one needs to be in a constant state of panic, it could be worthwhile to contemplate the possible ways of mitigating any unexpected roughness.

Exchange-Listed Options To The Rescue

One method of preparing for the unknowns is exchange-listed options. When option strategies are done right, they can be useful as a defensive investing component, as well as for a client seeking income opportunities, in ETFs.

But advisors who want to offer either alpha or tail-risk protection ideas may struggle with presenting options as a genuinely viable asset class, especially since options on occasion are dismissed as introducing new risk, rather than serving as a tool to manage it.

Randy Swan, the founder, CEO and lead portfolio manager of Swan Global Investments, says that mindset has to change. Swan recalls that before the 2008 financial crisis, many advisors were reluctant to consider options.

The crisis made the world dramatically rethink how to manage and mitigate risk, while putting a sizable dent in modern portfolio theory. But a decade later, the advisor set remains hesitant about options.

"You've got to spend a lot of time educating advisors," Swan said. "People tend to stick with what they know, even if it's not the best solution."

Growth & Liquid Markets

It isn't overly difficult for an advisor to have a conversation with a client when a down week or month can be attributed to the whims of the market. What can be more challenging is to formulate a real-world option strategy for an ETF portfolio.

However, ETF clients who are concerned about diving in to a new arena may take some comfort in knowing that volume in exchange-listed options has been growing.

Based on data from The Options Clearing Corporation ("OCC"), a regulated central counterparty that clears options for 15 U.S. exchanges, average cleared ETF option volume through Sept. 30 was more than 7 million contracts a day. That was up 16% from the same period in the prior year. Total cleared ETF option volume through September was above 1 billion contracts.

In other words, an advisor who overlays options on ETFs is not, in general, going to be introducing clients to an illiquid market, though it's true that not all ETFs themselves have significant volume, and the possibility always exists that they can close.

It also needs to be noted that options aren't available on every ETF, although hedging opportunities may exist, even if the client's ETF holdings don't have direct option equivalents.

Benefits Of Pairing ETFS & Options

Pairing ETFs and option strategies may warrant particular consideration today given the extraordinary growth of the ETF industry.

According to the survey, Reshaping Around the Investor: Global ETF Research 2017, from Ernst & Young, assets in the global ETF universe soared from $417 billion in 2005 to $4.4 trillion in September 2017.

Still, the same report says that ETF investors should be aware that "questions persist over the possible performance of ETFs in a financial crisis." But if they're applied carefully, listed options might be part of the solution.

While options aren't exclusively for protection, that is among their primary strengths.

In fact, one of the darkest days in financial market history had an important part in driving the use of exchange-listed options, because it led to the formation of The Options Industry Council (OIC), an industry resource funded and managed by OCC, a quarter of a century ago.

"In 1992, the exchange-listed options industry was at a crossroad, because exchange-listed options had been lumped in with other financial derivatives products that were held responsible for the crash of 1987," Mary Savoie, OIC's executive director, wrote in a blog post about the organization. "This occurred despite the fact that exchange-listed options performed very well throughout that market turbulence."

OIC and the U.S. option exchanges worked together in the years after the crash—Oct. 19, 1987, a day the Dow Jones industrial average fell more than 22%—to restore investor interest in the market. The effort worked: OCC cleared over 4.3 billion option contracts in 2017. That year, ETF options made up around 37% of the option market's total volume.

"I definitely think volume is going to continue to increase, and you'll see more players in the space," Chris Hausman, Swan Global's director of risk management and chief technical strategist, said of the options landscape. Eventually, he believes ETF and index options may be more in demand than single-stock options, currently the largest segment.

Building Confidence Through Education

Even so, many advisors can't get comfortable with the idea of option strategies for their ETF clients. A 2017 study commissioned by OIC and conducted by Cerulli Associates found that, of advisors not currently using options with clients, 49% of them "would not feel confident" adding ETF options to a portfolio.

"Education can lead to confidence," Savoie says. "When an advisor has a better understanding of exchange-listed options, he or she can present strategies that can help reach the client's financial goals."

Swan offers a way that advisors can keep the conversation relatable when they're discussing ETFs and options: "Most people insure every aspect of their lives. We always start from that concept of insurance."

His approach is based partly on the notion that most clients aren't going to demand absurdly high returns. What they really want is an opportunity to realistically outpace the market and to limit losses.

"People who are somewhat risk-averse like the concept of hedging out their risk," Swan said.

Sound Starting Place

Options can seem to be complex instruments. However, the risk management framework is a sound starting place that may help advisors and their clients have a meaningful talk. For instance, adding a protective put position to a long ETF holding isn't a difficult strategy to deploy, but it can lend quite a bit of comfort against a sell-off.

Undoubtedly, some advisors are at their best during times of market stress, but generally speaking, the smart solutions emerge from the preparations made on quieter days. That doesn't mean advisors should just rely on routine thinking, though.

Hausman argues that a standard portfolio mix of 60% equity and 40% fixed income isn't necessarily capable of producing satisfactory performance for today's clients, and may not be ideal for another crisis. The right options can make a difference, he believes.

"Anytime you employ options in a portfolio, what you're trying to do is alter the return distribution," he said.

Markets won't always behave as expected. Negative surprises can't be foreseen every time, and they can't be completely hedged away. But the effects on a client's ETF portfolio can be reduced. That's why it can be productive to explore the options—all the options.

If you're ever in doubt, just remember how 2018 started, when we got another reminder that vigilance will always be needed.

Eric Cott is the director of financial advisor education for The Options Industry Council

Options involve risks and are not suitable for everyone. Individuals should not enter into options transactions until they have read and understood the risk disclosure document, Characteristics and Risks of Standardized Options, available by visiting OptionsEducation.org. To obtain a copy, contact your broker or The Options Industry Council at The Options Industry Council at 125 S. Franklin Street, Suite 1200, Chicago, IL 60606.

Copyright © 2018. The Options Industry Council. All rights reserved.