ETF Options Strategies

"The world has discovered the world of ETFs, but like a boat above the ocean's surface it only sees the tip of the iceberg," says Bernie Schaeffer, chairman and chief executive of Schaeffer's Investment Research, an options analysis firm in Cincinnati. "But underneath the surface, like a huge, hidden iceberg, lies the world of ETF options, which you can use to protect portfolios or sell to get additional income. There are all kinds of wonderful things you can do with ETF options."

In essence, ETFs are index mutual funds that trade like stocks. As such, ETFs and corresponding index funds share the same baskets of securities. A crucial difference is, mutual funds price once a day while ETFs fluctuate throughout the session. Investors have more flexibility when it comes to getting into and out of ETFs, though that flexibility comes at a price. As with stocks, there's a brokerage commission on each ETF trade. Shares of no-load mutual funds can usually be purchased without transaction fees being added.

The availability of options on ETFs layers yet another benefit into the equation. For a small fee called a premium (more on this later), individual investors can make big bets on the direction of the indexes underlying ETFs. These indexes run the gamut from narrowly focused ones like the 30-stock Dow Jones Industrial Average to broadly diversified ones like the Wilshire 5000 total-market index. Properly executed trades involving ETF options offer the chance to parlay significant gains from investments smaller than buying the shares outright. It's possible to minimize downside risk too.

"Prior to ETFs you could only change your risk profile in relation to the total market through index options and futures, which are riskier and harder to manage," says Sander Gerber, chief executive of XTF Advisors, a New York provider of ETF asset-allocation strategies and investment services. "The beauty of ETF options is they allow a retail guy to play like an institution. It lets you customize your risk exposure to the whole market as opposed to having to do it against each individual stock."

Before we lay out specific strategies, here's a brief explanation of how options work. (For a more thorough discussion, visit our Options Center.) An option contract gives an investor the right to buy or sell a security at a specific price prior to the contract's expiration date. In exchange for this right the buyer of the option contract pays the above-mentioned premium, which amounts to a fraction of the total potential value if the contract is exercised. There are two basic types of options. A call option gives the holder the right to buy a security; a put option, to sell it.

Investors expecting a market rally in an underlying index might buy call options on a corresponding ETF, which would give them the right to purchase shares of the ETF at a specific price, called the strike or exercise price. Buyers of options are called holders, and sellers are writers. Call holders aren't obligated to exercise the options, but should they the writers are obligated to sell shares at the strike price. If the option isn't exercised because, for example, the index moved in the opposite direction than the buyer expected, then the holder is only out the premium that was paid for the contract. The writer of the option contract pockets the premium either way.

The absence of options from the hype surrounding ETFs might be attributed to the perceived complexity of options trading. Investors' eyes tend to gloss over whenever the subject is broached. We won't pretend options trading is simple, but we will offer these examples of how ETF options strategies can be employed to both protect profits and maximize returns.

Take the case of the Dow. On Monday, Merrill Lynch (MER) lifted its target for the widely followed average to a range of 12400 to 12600 from 11300 to 11500. Instead of buying 100 shares of the Diamonds Trust (DIA), an ETF that tracks the Dow, you could buy 100 shares of the Diamond's December 100 call option. Wednesday, the industrials closed at 11643, and Diamonds at $116.56. The option gives you the call holder the right to buy Diamonds at $100 anytime before the contract expires in December. Each option share costs $18.70, so for 100 options you'd risk just $1,870 instead of the $11,656 you'd pay for 100 Diamonds. If the Dow rallies to 12600, the options would pay about $2,600. That's an $730 profit, or 39% return on investment. Compare that to the Diamonds rising to $12,600. That's a $944 profit, but only an 8% rate of return. That's the power of leverage. (Of course, if the Dow fell the contract would likely expire unexercised and you'd have nothing to show for the $1,800 premium that you paid.)

Options can also protect portfolio gains, acting as insurance called a hedge. Say you own 100 shares of the Energy Select Sector SPDR Trust (XLE), an ETF that tracks a basket of oil industry stocks. While bullish on energy, you fear oil's price will fall this summer. And you don't want to sell the shares, because you don't want to pay capital-gains taxes.

You can limit your risk by buying put options. (Remember, the holder of a put has the right to sell shares at a specific price.) On Wednesday, XLE closed at $59.50. The premium for each XLE September 60 put costs $3.60, or $360 total. If oil falls and the XLE drops to $50, the ETF shares would lose $950 ($59.50 minus $50, times 100). But if you sell XLE at $60, as the put contract allows you to do, and buy back shares at $50, then you make $1,000. Subtract the $360 premium, and the option returns $640, protecting most of the fallen ETF's lost profit. If instead XLE rises above $60, you lose the $360, much like you lose car insurance premiums every year you avoid an accident. And if you want to reduce the cost of the hedge, you could sell an XLE September 70 call, at 55 cents, or $55. This would reduce the hedge to $305. The downside of this is if XLE moves higher than $70, then you don't benefit because you have limited your upside gain to $70.

"There are many different strategies you can employ to enhance returns from protecting a whole portfolio to protecting just one sector," says Marty Kearney, senior staff instructor at the Options Institute, the educational arm of the Chicago Board Options Exchange. "Any strategy you can do with a stock or index you can use with an ETF. However, while index options settle in cash, ETFs, like stocks, settle in shares."

We'll admit that options aren't for everyone. Putting together successful options trading strategies requires careful research. But the potential rewards offered by ETF options just might make the time and effort worthwhile.