What Every ETF Investor Needs To Know About Options

by on June 11, 2013

ETFs have become a staple product in the investing landscape; with more than 1,400 ETFs to choose from, there is one, or several, that provides access to almost every type of financial product available. While this diverse group of ETFs can provide exposure to a specific niche within the economy, the ETF may be too risky, or not volatile enough to suit an individual’s needs. By combining options with ETF trading, investors can fine tune their financial goals, through reducing risk, increasing exposure, or creating a synthetic position not available by purchasing ETFs alone [Download 101 ETF Lessons Every Financial Advisor Should Learn].

What Are Options?

An option is the ability to buy or sell an underlying instrument such as a stock or ETF, at a pre-defined price (strike price) within a certain time frame (by the expiration date). One option provides access to 100 shares.

If you believe a stock will rise above a specific price before the option expires, you’d purchase a call option. If you believe a stock will drop below a specific price before the option expires, you’d purchase a put option.

In order to buy an option you will pay what is called a premium – a fee paid to the seller of the option for the opportunity to profit from an ETF’s movement. How premiums are calculated is a complex issue, but, generally, the more volatile an instrument and the longer to maturity the greater the price of the option [see also 10 Questions About ETFs You've Been Too Afraid To Ask].

As an investor, you can buy or sell options. If you buy options, you can potentially profit if the underlying instrument moves in the right direction for you; if it doesn’t, all you lose is the premium you paid. If you sell options–also called “writing”–you collect the premium, but you must deliver the ETF at the strike price to the option buyer if it is profitable for them to do so.

Why Use Options?

Investors use options for various reasons, one of the main ones being speculation. If you believe an ETF will rise in value, you can purchase a call option. This gives you the opportunity to profit from a 100 share position–or more if you purchase more than one option–but at a fraction of the cost since you don’t need to buy the ETF shares directly. You only pay the premium, but can profit handsomely if the ETF moves in your favor significantly [see How To Swing Trade ETFs].

This essentially means options are a leveraged product, providing significant upside if you are right. For example, if you buy a call option that costs $1, or $100 total (plus commissions and fees) for one contract of 100 shares, and if the underlying ETF moves many dollars higher, you could make several times your initial investment – much more than you would have made by just buying the ETF.

The flip side of this is that you can sell options for income. One of the most common methods for doing this is called “covered call writing”. If you own shares of an ETF that you think may go down short-term but you don’t want to sell, or you think the ETF will not rise, then you can write call options. For each option you sell, you will receive the premium [see 101 High Yielding ETFs For Every Dividend Investor].

When buying options, your risk is controlled. You only lose the premium if the option doesn’t increase in value enough to make you a profit; this is another reason investors choose to use options at times instead of buying an actual ETF.

Hedging is another reason options are used. If you’ve accumulated a position in an ETF and believe the value may drop, but you don’t want to sell your position, you can purchase a put option to hedge. If your ETF does drop in value, the put option will increase in value, offsetting all or some of the loss. Similarly, if you have a short position, you can hedge it by buying call options.

What Are the Risks?

As an option buyer, you will lose the entire premium you paid if the option expires worthless.

Options sellers face potentially much greater risk, as they can lose much more than the premium they receive for writing the option.

If don’t own the ETF and you write calls (“un-covered”) you face potentially unlimited losses since the price of an ETF can theoretically keep going up. Therefore, only write calls equivalent to the number of ETF shares you own.

How Do Options Work?

Option values fluctuate constantly, just like the price of other assets. Value is determined by supply and demand, but also by intrinsic value and time value.

Intrinsic value is based on the proximity of the underlying security’s price to the strike price. A call option is in-the-money and has intrinsic value if the security’s price is greater than the strike price. A call option is out-of-the money and has no intrinsic value if the security’s price is less than the strike. Similarly, a put option has intrinsic value (in-the-money) if the underlying security’s price is below the strike. It has no intrinsic value (out-of-the-money) if the security’s price is above the strike [see 13 ETFs Every Options Trader Must Know].

Even if an option is out of the money, the option may still have value. This value is mostly related to time and volatility. If the option does not expire for some time–indicated by the options expiration date–there is still time for the option to move into the money, and that possibility gives it some value. As the expiration date draws near, the option will lose its time value. This is called time decay, as the probability of the option moving into the money is reduced as the expiration date moves closer.

Volatility also plays a big role in the value of an option. The more volatile an underlying security, generally the higher the value of the option. This is because volatility increases the chance of the option moving into the money, even if temporarily.

As a buyer or seller of options you’re interested in value, but also exercising and assignment, respectively. As an option buyer, you can sell your option before the option expiry date, realizing a profit or loss on the option value. This is how an overwhelming majority of options are traded.

Alternatively, you can choose to exercise your option. This means you notify your broker, letting them know you wish to exercise the option, and buy (in the case of a call) or sell (put) the underlying ETF at the strike price. This must be done before the expiration date.

If an option is exercised, it is assigned to an option writer. If an option writer is assigned, they must provide the shares to the option buyer at the strike price. Expect to be assigned if you don’t close out your written calls which are in-the-money before expiration date.

Bottom Line

Options are a useful product for ETF investors to consider. Buying options provides a leveraged investment which can be used to speculate, hedge or take part in a more dynamic strategy. Risk is controlled as the losses are limited to the premium paid while selling options is another alternative, which provides income to the option writer.

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Disclosure: No positions at time of writing.