An exchange-traded fund (ETF) is a collection of assets that track specific investment categories.
For instance, SPY tracks the S&P 500. ETFs can also track sectors and industries, such as energy and technology. ETFs often support options, but is it a good idea to trade options on ETFs?
ETFs may be less risky than holding individual stocks, but they are not risk-free. Investors who want control of ETFs without allocating too much capital can buy calls.
The premiums for the calls are usually a fraction of the price of the ETF. If the price of the ETF goes against the investor, she can let the contract expire. The risk is limited to the premium.
Investors can also use puts on ETFs to hedge the overall market risk. Investors who feel a bull market has run its course can buy puts on an index ETF, like the SPY. If the market does fall, the SPY will provide protection.
The challenge with this strategy is knowing how much protection to buy. When an investor loads up on too many puts, they expire worthless if the market does not fall.
Another form of protection that investors use is covered calls. Some investors choose to write covered calls on their ETF holdings.
For every 100 shares that an investor owns, one call contract can be written. This provides immediate income from the premiums.
These premiums could be considered protection or added income if the market does not reverse. The amount of protection is limited to the premium of the covered call, however.
When investors purchase ETFs, they are subject to the fees associated with ownership. While these fees may indirectly affect the premiums of these instruments’ options, the impact will be negligible.
Pitfalls of options on ETFs
One of the biggest pitfalls for ETFs is the volatility is lower than individual stocks. Volatility is the juice that powers options prices to rise.
The diversity of the assets held in ETFs is what causes their volatility to be lower. There are exceptions to this, but it is something to consider when buying options on these instruments.
Investors should pay attention to the liquidity of the options they choose. For an index ETF like SPY, liquidity is usually not an issue, as they are highly liquid instruments. However, the options on some ETFs may not be liquid enough to obtain attractive premiums.
Options buyers are not eligible for dividends. For ETFs paying high yields, these buyers may be missing out on a substantial recurring income stream.
Dividends can help temper losses of a stock or portfolio. Options holders are not eligible for bond ETF income streams, as well.
Many investors are misinformed about the risks associated with ETFs. Diversification can lower risk.
However, a portfolio filled with risky assets will counteract that diversification. Also, ETFs that are sector-based (like oil or metals) will take a big hit when those sectors decline.
Finally, precise tracking of an index by managers of ETFs is not possible. Managers of these instruments hold a certain amount of cash to pay expenses and other fees.
Therefore, they are subject to some tracking error. The amount of tracking error can affect the fund’s performance. The price of the options may be affected, as well.