Why Use Options Overlays On ETFs?

Fundamental analysis and ETF options together? You better believe it.

Reviewed by: Eric Cott
Edited by: Eric Cott

Investing strategies based on fundamental analysis have been popular for decades, because poring over fundamentals to support buying and selling decisions makes perfect sense. ETFs have allowed fundamentals-minded investors a simple way to gain exposure to narrow industries and broad indexes, and they’ve grown in adoption.

But there is more an investor can do to a fundamentals-driven ETF strategy to potentially gain income or find a better entry price thanks to the options market.

First things first: Options aren't necessarily appropriate all the time. However, when aligned with a client's risk profile, options can be a powerful accompaniment to potentially enhance returns. That is what option overlays are all about.

How Options Overlays Work

With an overlay, an investor decides to sell options on a security they own, generating premium income in the process. Along with accumulating income, an overlay strategy may have the secondary objective of acquiring more of an asset or closing out what is already owned.

Here is an example. Suppose an investor is long an index-tracking ETF. He or she could sell a covered call, with each call option representing 100 shares of the underlying ETF, and collect income from the option sale. Should the ETF climb above the exercise price of the call option, the underlying ETF could be called away, but the investor will keep the income (the option premium collected) and whatever profits might have been made on the initial ETF investment, up until the exercise price of the call option.

It is like a limit order, except that, with the overlay, the investor is paid to wait while the ETF rises toward the established exit price. Basically, the investor is determining that on the day they sold the call option, they’re willing to sell their ETF at the strike price, up until expiration.

Of course, if a client's ideal scenario is to keep the underlying security rather than have the position closed, assignment risk may be lessened by selling calls that are farther out-of-the-money. Doing so might enable the client to retain their underlying investment and collect ongoing premium income, provided the process is repeated and the options continue to expire without reaching the strike price.

The trade-off probably would be accepting a smaller premium with each sale, since premiums tend to decline as strikes get more distant from the current price of an underlying.

Not Just For Institutions

But how can options coexist with fundamental analysis?

"Options offer so many strategies, including some with an insurancelike purpose and others for establishing a more favorable acquisition price," said Mary Savoie, executive director of the Chicago-based Options Industry Council. "These concepts in no way conflict with a philosophy underpinned by fundamentals. In our view, they align."

The market for ETF options is substantial, accounting for almost 40% of the total 5.14 billion option contracts that were cleared in 2018 by OCC. Although not every ETF will have listed options associated with it, many do. Paul Finnegan, VP of OIC, points out that ETF options have seen their cleared volume surge in the past decade.

"A large, growing segment of investors are realizing that the ETF options marketplace is an efficient tool for managing risk and seeking enhanced returns on underlying ETFs," he explained. "It is also important to stress that this market isn't only for institutional use. Equity, index and ETF options can be just as meaningful for the retail investor who is concentrating on fundamental analysis in their strategies."

Worth The Time To Learn

This is where financial advisors can have a key role, as they're ideally positioned to get the word out to their clients about the opportunities and the risks that can be found with options.

Fariba Ronnasi, founder and chief executive of Elite Wealth Management in Kirkland, Washington, understands the challenge of educating clients. Her firm, which focuses on separately managed accounts for larger portfolios, deploys options to create income streams for clients who have fundamental strategies.

The story she tells is instructive, because she makes it clear there is a widespread need for education on options, including how they can be applied as overlays to long positions.

"Many clients have no idea what overlays are," she said. "They don't know covered calls or stock versus index options. It is a lot of educational work on our end to explain to the client what we do and why selling options makes sense. Once you start that conversation, clients get very excited about it."

One of her firm's strategies involves selling far-out-of-the-money covered calls on a client's assets, while using the value of the portfolio to sell far-out-of-the-money put options on an ETF that tracks the S&P 500. The client collects premiums on both the calls and the puts, in addition to holding whatever security they prefer in their portfolio, and still receive the dividends and interest income on the underlying holdings.

If the S&P-tracking ETF falls toward the put strike, the client could close the position and redeploy it at a lower strike. But if the ETF were to drop below the strike, leading to assignment, the client would use assets on hand to acquire the ETF. At that point, covered calls would be written on the long position, creating immediate income as well as a liquidation price.

"Ask as many questions as you want until you fully understand how it works," she advised. "Once you get it, you're going to love it."

No Risk-Free Lunch

To be clear, options aren't risk-free. Adding options creates a layer of complexity that has to be managed and monitored for any ETF portfolio.

Still, overlays shouldn't be viewed as an opposing force within the fundamentals-based approach to investing—they’re tools to support it. With time and research, it just may be that you'll develop a new perspective on options.

Eric Cott is the director of financial advisor education for The Options Industry Council, a resource managed by OCC, the world's largest equity derivatives clearing organization.

Options involve risk and are not suitable for all investors. 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. Copies of this document may be obtained from your broker, from any exchange on which options are traded or by contacting The Options Clearing Corporation, 125 S. Franklin Street, Suite 1200, Chicago, IL 60606.