ETF Options Income - Part 1: An Introduction

An options contract gives the owner the right, but not the obligation, to buy or sell a security at a predetermined price in a predetermined amount of time. The right to buy a security is a call option, while the right to sell is a put option. In order to generate income, traders sell options contracts and collect the premiums, but expose themselves to risk if the contract gets exercised.

For additional income ideas, check out a list of the top dividend ETFs using our ETF Screener.

The pricing of an options contract is affected by several factors such as volatility, time to expiration and the price correlation to the underlying security. These factors are commonly referred to as options Greeks, with each letter referring to a different options risk.

• Delta – The sensitivity between price shifts in the options contract and the underlying security. Values can range from 1.0 (perfect correlation) to -1.0 (perfect inverse correlation).
• Gamma – The degree of change in the Delta as the price of the underlying security moves.
• Vega – The degree of sensitivity of the options price to increases in volatility.
• Theta – Measures the erosion in the value of the options contract as the expiration date approaches.

There is no universal pricing method for putting a value on an options contract. In general, any factor that increases the options risk increases the price of the contract. Each of the risk factors illustrated by the Greeks, such as a longer time to expiration, above average volatility and high options price sensitivity to the underlying, all represent increased risks that get factored into the contract’s price.

For example, all things being equal, a call option that expires in two months will have a higher price than one expiring in one month. Options that experience large price movements are more risky and command a higher price.

The Black-Scholes Options Pricing Model is perhaps the most popular method of determining the price of an options contract. It’s a complicated formula that uses the following inputs to help calculate a value.

• Underlying security price – The current price of the security that the option is being written for.
• Put or call option – The price calculation is slightly different depending on whether the option is a call or a put.
• Volatility – The implied volatility of the underlying security often measured using the standard deviation.
• Interest rates – The risk-free interest rate often measured using the current yield on Treasury bills.
• Strike price – The price at which the options contract can be exercised.
• Expiration date – The date on which the options contract expires.

According to Bloomberg, ETFs account for more than two-thirds of the approximately $110 billion in options volume traded daily. Most ETFs offer options trading, but relatively few have an options market liquid enough to make it a useful trading tool. The most actively traded options contracts in the entire market belong to the SPDR S&P 500 Trust ETF (SPY A-). With over 24 million open contracts, this ETF accounts for around half of total options trading volume by itself on an average day.

Other ETFs active in the options market include the iShares MSCI Emerging Markets ETF (EEM A-), the iShares Russell 2000 ETF (IWM A-), the SPDR Gold ETF (GLD B) and the PowerShares QQQ ETF (QQQ B).

The strike price of the options contract and the current price of the underlying security determine whether the option is either in the money or out of the money. A call option whose strike price is below the current price would be considered in the money. For example, if a call option had a strike price of $85 while the underlying ETF is trading at $90, the option would be in the money since the holder has the option to buy the stock at below market price.

For puts, it’s a little different. A put option with a strike price above the current price would be in the money. For example, if a put option had a strike price of $95 while the underlying ETF is trading at $90, the option would be in the money since the holder has the option to sell the stock at above the market price.

Options contracts would be considered out of the money if the opposite of the above examples were true. Options where the current price and the strike price are the same would be considered at the money.

In-the-money and out-of-the-money options can both have value. For example, a call option in which the strike price is $17 but the current price is only $15 can have value and be traded actively. Increased Greeks risk adds to the value of the option contract and can result in an out-of-the-money options trading for several dollars per share.

Trading in options contracts is very different than simply trading in the underlying ETF. Since each options contract represents 100 shares of the underlying security, investors can use little money to gain a lot of exposure to an ETF. Therefore, options add synthetical leverage. In this sense, the percentage gain-and-loss potential is much higher with options.

To add to that, options may also have high sensitivity to volatility of the underlying asset’s price changes. The higher the volatility, the more the options price will fluctuate.

Dividends of the underlying affect options prices as well. This is especially the case if there’s an unexpected dividend announcement. For call options, a dividend announcement will decrease the price of the option. Whereas, for put options, a dividend announcement will increase the price of the option.

Traders also have the potential of losing their entire investment if their option expires out of the money. Take, for example, an investor who buys an ETF for $100 per share and holds it for one year. At the end of the year, the ETF still trades at $100. The investor in this scenario has not gained or lost anything. The same trader may buy a call option with a $100 strike price that expires in a year for $5. If the ETF remains at $100 one year later, the value of the option will erode to zero by expiration representing a 100% loss on investment.

When used as a hedging tool, options can possibly limit some return potential depending on the structure of the hedge.

Instead of buying options contracts, traders can sell them to other traders and collect the options premiums. Many traders use a covered call strategy in order to produce an “income” that can enhance a portfolio’s overall return. A covered call strategy involves holding a long position in an ETF, while simultaneously selling a call option on the same ETF. A trader in this situation typically sells an out-of-the-money call option in hopes of collecting the premium while seeing the option remain out of the money and expiring worthless.

If you’d like some ETFs that sell options for you, check out the Top 3 Covered Call ETFs.

The risk in this strategy is that the price of the ETF rises above the strike price. In this case, the trader you sold the call option to will likely exercise the option and purchase your shares at a discount to the current market price. This would result in the covered call writer forfeiting some potential gains from their long ETF position that they otherwise would have earned had they not sold the call option.

For more strategies, come back to our ETF Trading Strategies category page on a regular basis.

Options trading can be confusing, but it can also be a great way to help improve your portfolio’s overall return.

Further Reading
To learn more about how to earn income using options, check out the rest of our ETF Options Income series:

• ETF Options Income – Part 2: Earn Income with Weekly ETF Options
• ETF Options Income – Part 3: Increase Your ETF Yields with Call Writing
• ETF Options Income – Part 4: Increase Your ETF Yields with Put Writing
• ETF Options Income – Part 5: Increase Your ETF Yields with a Strangle