“In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” – Warren Buffett
Most long-term investors consider options to be risky and complicated, as Warren Buffett seems to imply in the quote above. But some options strategies provide an effective way to minimize risk: covered calls provide an immediate premium and no downside risk – just opportunity cost – while protected puts let investors limit their losses by establishing a price floor for their long stock position or hedge an entire portfolio with index puts.
For ETF investors, options provide a great way to realize the same benefits on entire indexes rather than individual stocks, which could result in a higher long-term, risk-adjusted returns.
Generating Income
Covered calls are one of the most popular options strategies used by ETF investors, providing a great way to generate income in a flat or modestly up-trending market. On a basic level, the strategy allows an investor that owns an ETF to write a call or sell the rights to that stock to someone else if the price reaches a certain level before expiration. The ETF investor immediately receives the premium and only sells the stock if it reaches the predefined level before expiration.
The strategy works best when the ETF investors have a neutral to slightly bullish sentiment and either establish the position when first buying the ETF or after the ETF has begun to move higher. When entering the position, it’s usually best to sell out-of-the-money call options at a higher price or premium than was paid for the ETF since it increases the likelihood that the option will expire worthless and/or the investor makes a profit in the end.
Let’s take a look at a basic example:
- Buy 1,000 shares of the S&P 500 SPDR ETF (SPY ) at $195.00 on Sep 1.
- Sell 10 S&P 500 SPDR ETF call options with a 197.00 strike price for $2.66 for Oct 1.
With $2.66 worth of income from the premium ($2,660), the ETF investor has an immediate 2.66-point downside protection to the existing position – or to $192.34. The trade-off is that the maximum upside is $197.00, or a profit of $4,660, while the maximum downside is still $195,000 minus the $2,660 premium received that provides a buffer. If the stock rises to $196.00, however, the investor would keep the $2,660 and the stock after October 1.
Establishing a Maximum Loss
Protected puts are another popular strategy used by ETF investors to establish a maximum loss on their position by securing a right to sell at a certain price. Instead of selling the ETF outright, which could generate capital gains taxes and increase churn costs, these options enable investors to realize the same benefits as selling the stock without actually doing so by offsetting the losses with gains from a put option contract on the ETF.
Let’s take a look at a basic example:
- Hold 1,000 shares of S&P 500 SPDR ETF (SPY ) at $195.00 on Sep 1.
- Buy 10 S&P 500 SPDR ETF put options with a 170.00 strike price for 38 cents for Oct 1.
In this case, the investor is worried about a dramatic fall in the S&P 500 and would like to establish a maximum loss of $25,000 on the position in the event the ETF falls to $170.00 per share. The put option to hedge against that potential for the entire $195,000 long stock position loss costs just $380.00. While the $380.00 will likely be a complete loss if the ETF remains above $170.00, the contract may provide peace-of-mind for the investor.
The Bottom Line
Covered calls and protected puts are great strategies for protecting ETF portfolios from downside by either offsetting losses or establishing a price floor. However, investors should be aware of the risks associated with even these conservative strategies, including the risk of having to sell the ETF with covered call options (or pay off the difference) as well as the risk of potential losses in terms of opportunity costs or premiums paid.
Image courtesy of suphakit73 at FreeDigitalPhotos.net
