Exchange-traded funds (ETFs) have rapidly grown in popularity over the past decade, driven by their low costs, high liquidity and built-in diversification. While trading volumes have soared into the trillions of dollars per year, the growth in ETF options trading has been a somewhat recent phenomenon as investors look to hedge their positions or purely speculate. ETF trading volume has doubled over the past five years to 70% of option trading volume.
In this article, ETFdb takes a look at why ETF options are growing in popularity and some implications for investors in these markets.
Why the Transition
Many large institutional traders have focused on equity index options as a way to buy protection across an entire asset class. For instance, a trader may purchase $1 billion worth of S&P 500 index puts to hedge a long equity portfolio against a broad market decline. These traders are now purchasing put options on the S&P 500 SPDR ETF (SPY ) instead, drawn to the idea of hedging a position with options on a fully funded security.
While SPY is by far the most popular ETF option, accounting for roughly half of all equity option volume, the iShares Russell 2000 ETF (IWM ), PowerShares QQQ Trust (QQQ ) and iShares iBOXX USD High Yield Bond Fund (HYG ) all rank in the top 10 equity options by dollar volume. Tech companies like Apple Inc. (AAPL), Amazon.com Inc. (AMZN), Alphabet Inc. (GOOG) and a few others are the only stocks coming close to ETFs in terms of dollar volume.
The ongoing increase in ETF liquidity has been a key driving force behind the adoption of ETF options. In mid-2015, the trading volume of ETFs reached a trailing 12-month $18.2 trillion, which surpassed U.S. GDP of just $17.4 trillion. The surprising thing is that ETFs only hold about $2.1 trillion in assets, which means that turnover was roughly 870%. In contrast, U.S. stocks turned over just 200%, meaning ETFs are increasingly being used for active trading.
Benefits & Drawbacks
The transition from equity index options to ETF options has a number of benefits and drawbacks for individual ETF investors and the broader market.
Some key benefits include:
- Greater Liquidity: Investors always prefer liquidity to illiquidity since it helps ensure that prices are accurately reflected and transactions are frictionless. For instance, HYG’s liquidity relative to the underlying primary market is partially due to ETF options.
- Better Pricing: The option market is historically illiquid when it comes to many areas of the market, but greater trading volume could help improve pricing in these cases. In other words, option prices may be more accurate with the greater trading volume.
Some key drawbacks include:
- Equity Impact: The options market occasionally spills over into the equity market when it comes to expiration dates and other factors. Greater open interest in options markets could equate to greater impact on the equity markets at these times.
- Fewer Index Options: The move out of the index options market and into the ETF options market could mean fewer index options in the future. In essence, options traders will be forced to rely more heavily on ETF trading than on raw index movements.
The Bottom Line
ETF options have grown in popularity over the past five years, driven by increasing liquidity and a fully funded security backing the option. While the transition shouldn’t come as a big surprise, investors should consider the potential benefits and drawbacks associated with it. These dynamics could begin to affect ETF investors more and more over the coming years.
