The reduced cost structure of ETFs relative to traditional actively-managed mutual funds is no doubt responsible for a substantial portion of the billions of investor dollars that have poured into these securities in recent years. But investors seeking enhanced flexibility are also flocking to ETFs from mutual funds, attracted by unique features that expand the realm of investment possibilities. Unlike mutual funds, ETFs can be sold short, allowing investors to capitalize on declining prices. And in recent months, an increasingly efficient options market for ETFs has developed, providing investors a new way to leverage bets on fund movements and implement unique trading strategies.
As the ETF industry continues its expansion at a breakneck pace, the market continues to develop, with new innovations such as options trading only making ETFs a more attractive alternative to high-cost mutual funds. A few statistics from the CBOE’s most recent press release provide some insight on the size of the market for options on ETFs:
- Total ETF option volume for May was more than 23.8 million contracts (each of which represents 100 shares of the underlying security)
- Total May ETF option volume represented a 20% increase over May 2008 and a 3% increase over April results
- Average daily volume on the CBOE in May 2009 was more than 1.1 million contracts
- Through May, approximately 24% of total CBOE contract volume was related to ETFs
- The five most active ETF options on the CBOE in May were SPY (7.4 million contracts), QQQQ (3.7 million), IWM (2.6 million), XLF (1.9 million), and EEM (960,000)
- Options are traded on approximately 40% of the ETFs available today
How Investors Benefit
Options trading, while not for novice investors, is a favorite tool of many sophisticated day traders. Options greatly expand the number of investment strategies for investors, making it possible to profit (or lose) from any given scenario. Investors also like options because they can provide exposure to underlying securities with very limited risk. Of course a price is paid for limiting the amount of risk, but it is a worthwhile expense in the eyes of many. Finally, options allow the leveraging of assets. Since the premium on an option (the up-front amount paid for the right to buy the underlying at expiration) is usually only a fraction of the value of the security, investors can use options to place large bets without actually having to buy the underlying security.
Over the last year, equity market volatility reached record highs, with multiple-percentage point rises and falls happening with alarming regularity (volatility, as measured by the VIX, has declined significantly in recent months and now falls within a normal historical range). In such a volatile environment, many traders turned away from trading options on individual equities in favor of options on ETFs. Given the broad diversification benefits of many ETFs, swings in option values are generally much less severe than those of single stocks.
ETF Options Strategies
The number of potential strategies that options allow is truly astounding, so a thorough review of the possibilities is impractical. So here are a few of the most basic options strategies that can be implemented using ETFs (WhatsTrading.com provides very thorough coverage of the options markets for those interested in learning more).
- Covered Call: By holding a long position in and selling a call option on an ETF, an investor can make a profit if prices remain flat, but be protected from a loss in the event of price increases.
- Protective Put: By purchasing a put option and holding a long position in an ETF, investors protect themselves from losses while maintaining upside potential.
- Straddle: By holding both a call and put option in an ETF, investors stand to profit if the price of the underlying fund changes significantly, regardless of the direction.
While these options trading strategies are basic, they are popular among many sophisticated investors.
Extreme Leverage: Options on Direxion ETFs
Investors who really know what they’re doing (or at least think they know what they’re doing) have embraced options on leveraged ETFs as a way to bet heavily on short-term movements. As the options gurus at VIX and More point out, “there are very few trading vehicles out there with the potential to move as rapidly as options on triple ETFs, but…these ETFs offer a great deal of potential reward, paired with commensurate risk, of course.” Options on leveraged ETFs allow investors to generate amplified returns of a target benchmark while putting only a small amount of their own money on the line. For investors who can’t quite stomach the possibility of losses on an incorrect bet being amplified threefold, options on Direxion funds may have some appeal.