ETFs are great portfolio building blocks thanks to the low-cost, well-diversified nature of these products. Aside from buy-and-hold investors, active traders have also embraced these financial vehicles as viable tactical tools thanks to their ease-of-use and unparalleled liquidity. Furthermore, sophisticated investors have come to utilize options in conjunction with ETFs, further expanding the arsenal of available trading strategies that are ultimately designed to minimize risk [Download 101 ETF Lessons Every Financial Advisor Should Learn].
Options are a financial product that allow you to profit from fluctuations in an ETF without actually buying the ETF itself. Ultimately, this means it is less capital intensive to purchase an option. For example, if an ETF is trading at $50, to buy 100 shares costs $5,000 plus fees. Since an option only captures fluctuations, it may sell for $1—called the option premium–so controlling 100 shares only costs $100 plus fees [see 5 Important ETF Lessons In Pictures].
Options do have an expiry date though, and whether that expiry date is far away or near is a large determinate in the cost of an option; the further the option from expiry, the higher the cost of the option. The relationship of time-to-expiry and price is represented by the term Theta.
Since you’re not buying an actual ETF, you’re buying a derivative of it, the option will increase and decrease in value as the price of the ETF fluctuates. How much the option price moves relative to the underlying ETF is defined by Delta—or the relationship between changes in price of the two assets. Another measure used in options trading is Gamma. Gamma is primarily used to see how risk will change (delta) as the price of the ETF changes.
While these terms, called the Greeks, are important for developing a full understanding of how options work and are priced, most traders will benefit from simply knowing how, why and when to buy and sell call and put options. Option trading doesn’t need to be complicated [see 3 ETF Trading Tips You Are Missing].
A call option gives the right to buy an ETF at a specific price–called the strike price–within a certain time period.
Buying A Call Option
Assume you believe the price of the S&P 500 SPDR ETF (SPY) will rise over the next month. If it currently trades as $135, you can buy a call option with a strike price of $135 and with an expiry date of one month or more away. Remember though, the further the expiry date the more expensive the option, so don’t choose a further away expiry date than necessary. If the ETF moves above $135 your option will increase in value.
While the price of the options will vary with volatility and time to expiration, assume that buying a call option with a strike of $135 and an expiry date 6 weeks from today costs $1.20 per share, or $120 to control 100 shares. If the price rises to more than $136.20 ($135 + $1.20) you will have covered the cost of your option and any further upside is pure profit. If the ETF price rises to $138 and you decide to sell your options, you will reap a profit of approximately $138 minus $136.20, or $1.80 per share, or $180 less fees — not bad for a $120 investment [see also 5 Simple ETF Trading Tips].
On the other hand, if the ETF price declines, the most you can lose is the $120 you paid for the option, or you can try to sell the option before expiry to reduce the loss.
Your loss is limited to the amount you pay for the option. As the ETF or stock price rises it eventually reaches your break-even point. If it continues to rise your profits are unlimited.
Figure 1: Buying a Call Profit/Loss Graph. Source: CBOE Profit Diagrams
Most options traders choose to sell the option when they have accumulated a profit, instead of letting the option expire and exercising their right to buy the ETF shares. If the option is not in a profit position, it can be allowed to expiring worthless and you will lose the amount you paid for the option, or you can try to sell it before expiry to minimize the loss [see also Low Volatility ETFdb Portfolio].
Selling a Call Option
Selling a call option–called writing a call option–means you are giving someone else (the buyer) the right to buy an ETF at a specified price within a certain time frame. In exchange for this, you receive the premium that is paid by the buyer. Since you are giving someone else the right to buy the ETF at a specified price, if you don’t own the ETF—this is called “naked” call writing–and it rises in price considerably, you face infinite losses. At the same time your profit is limited to the premium you received for writing the option.
If you already own the ETF and write a call option—“covered” call writing—then your risk is limited, since you simply give your ETF shares to the buyer if they choose to exercise their right. In this case, you give up the upside potential of holding onto the ETF shares, but receive the option premium in exchange. Most traders write covered calls, as writing naked calls can be financially dangerous [see Buy-Write ETFs].
Assume you own 100 shares of the SPDR Gold Trust (GLD). You believe gold will rise over the long-term so you want to hold onto your shares, but believe gold will stay near current level, or even drop over the next month. To generate some money from your holdings, you decide to a write a call option.
As of December 14, 2012, GLD trades at $164, so you will write a call that will expire in one month, for a price higher than the current price – $170, for example. This is called an out-of-the-money or OTM call. You receive $0.46 per share for writing this option, or $46. If the price of GLD stays below $170 you keep the $46, and still own your ETF shares. If the price rises above $170 you will need to give your shares to the option buyer at $170, but you still keep the $46 [see 25 Things Every Financial Advisor Should Know About ETFs].
Figure 2: Covered Call Profit/Loss Graph
In general, as the ETF or stock price rises, your profit is limited. If the stock drops, you still face the loss from the declining ETF price, but it is at least partially offset by the premium your received.
A put option gives the right to sell an ETF at a specific price within a certain time period.
Buying a Put Option
A put option gives you the potential to profit from a price decline in a specific ETF. Therefore, by buying a put option you hope the price of the ETF declines so your put option will increase in value.
Assume you believe that the price of oil will fall over the next month, and along with it the price of US Oil Fund ETF (USO). The ETF currently trades at $32 so you buy a put option that expires one month from now with a strike price of $32.
The put option costs $1.15, or $115 to control 100 shares. Therefore the price needs to drop below $30.85—your breakeven point–in order for you to start seeing a profit. If the price rises or stays above $32, and you and allow the option to expire, your loss is limited to $115 [see The Total Cost Of ETF Investing].
Figure 3: Buying A Put Profit/Loss Graph
In general, your loss is limited to the amount you pay for the option. As the ETF or stock price falls it eventually reaches your break-even point. If it continues to fall your profits continue to rise, but are not infinite since the lowest price an ETF can go is $0.
Selling a Put Option
Selling or writing a put option means you are giving someone else (the buyer) the right to sell an ETF at a specified price within a certain time frame. In exchange for this, you receive the premium that is paid by the buyer.
Since you are giving someone else the right to sell the ETF at a specified price, if you aren’t short the ETF—“naked” put writing–and it falls in price considerably you face large losses. At the same time your profit from the option is limited to the premium you received for writing it.
Covered put writing is not that common either, but is used in some cases to incrementally increase the return on your short positions. Assume you are short the Silver Trust ETF (SLV), and believe it is going to stay stagnant or maybe even slightly increase in value, but not enough for you to worry about closing out your short position. You sell a put option that expires in one month at $29 – well below the current market price of $31 for example. For this, you receive an option premium $0.15 per share, or $15 for 100 shares.
If the price rises slightly the premium serves to offset some of the loss on your short position. If the price declines you profit on your ETF position down to $29, plus the premium you received. If the ETF continues to drop below $29 though your gains are capped as the put buyer will exercise their rights.
Figure 4: Covered Put Profit/Loss Graph
The Bottom Line
Option prices are determined by measures such as delta, gamma and theta. Yet, simply understanding how, when and why to buy or sell call and put options can get you started. Adding options to your ETF trading strategy can help maximize your risk-adjusted returns over the long-haul, however, keep in mind that it takes both dedication and patience when it comes to mastering these powerful financial derivatives. Current option prices are found on the CBOE website.
Disclosure: No positions at time of writing.
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