In April 1973, Sen. Harrison A. Williams, D-N.J., chairman of the Senate Banking Subcommittee on Securities, made the following statement to mark the one-year anniversary of the Chicago Board Options Exchange: “To my mind, this exchange is unquestionably the most exciting and potentially important experiment now occurring in the securities industry.”
I’m sure that he could not have imagined how accurate his statement would prove to be.
In April 2009, average daily volume at the CBOE was just over 5 million contracts. Year-to-date through April, total CBOE volume was a remarkable 378,274,067 contracts. Since each option contract typically covers 100 shares of the underlying security, average daily option volume for April was equivalent to more than 500 million shares of common stock. It’s obvious from the numbers that investors have embraced options and are using them on a regular basis.
Twenty years after Mr. Williams declared the CBOE one of the most important experiments in the securities industry, another watershed event occurred that fundamentally changed the way investors build and manage their investment portfolios. In early 1993, the first domestic exchange traded fund started trading. Since ETFs trade like stocks, it was a logical step for the CBOE to offer options contracts on ETFs.
Approximately 40% of all ETFs have underlying options contracts. During April, ETF option volume on the CBOE totaled 23 million contracts, with average daily volume at 1.1 million contracts. Since each option contract covers 100 shares of the underlying ETF, the equivalent share value was roughly 110 million shares per day. Year-to-date through April, approximately 24% of CBOE contract volume was options on ETFs. The four most actively traded ETF options on the CBOE in April were the SPDR S&P 500 ETF Fund (SPY), from State Street Global Advisors in Boston; the PowerShares Exchange Traded Fund (QQQQ), from Invesco PowerShares Capital Management LLC in Wheaton, Ill.; the iShares Russell 2000 Index Fund (IWM), from Barclays Global Investors in San Francisco; and the Financial Select Sector SPDR Fund (XLF) from SSgA.
Today, millions of investors use options on ETFs to help reduce risk, maximize return and build better portfolios. One reason so many investors are choosing ETFs over traditional mutual funds is that they offer more strategy choices, such as options contracts. This is in addition to other ETF advantages, such as lower internal costs, greater tax efficiency, transparency, index-based performance and access to a wider range of asset classes. The advent of ETFs and the ability to trade options on some ETFs truly has revolutionized portfolio management.
However, keep in mind that options are risky. Do not use them unless you fully understand the risks involved.
With that out of the way, covered-call writing and protective puts are two popular ways to use ETFs and options.
Covered calls with ETFs
Covered-call writing is one of the most commonly used option strategies. The primary advantage is that the strategy is no riskier than owning the underlying ETF, and it provides an options premium that can help increase returns in a flat or slightly down market. To initiate a covered-call-ETF strategy, the investor sells one call option for every 100 shares of the underlying ETF owned. For example, purchase 100 shares of SPY at $91 per share and simultaneously sell one SPY September 2009 call option with a strike price of $101 for a premium of $2.60. The premium received reduces your cost basis on SPY by $2.60 per share to $88.40, not including trading costs. If we fast-forward to option expiration in September, we see the following possibilities. If SPY has declined by 2.9% to $88.40 per share, you still break even despite the drop in price. If SPY is over $101 (the strike price on the option), your shares are called away at $101, resulting in a profit of 14.3%. The 14.3% profit is realized even though the price of SPY increases by just 10.9%. The additional return is due to the option premium you receive. Finally, if SPY is below $88.40, your position is at a loss. The amount of the loss will depend on how far below your break-even price SPY is trading. At expiration, you can sell another covered call, sell the shares of SPY or hold in anticipation of future gains.
Protective put with ETFs
The second strategy we will discuss is combining a put with an ETF. This is often called a protective put. To implement the strategy, you purchase one put option for each 100 shares of the ETF you own. For example, purchase 100 shares of SPY at $91 per share and purchase one SPY September 2009 put with a strike price of $81 for a premium of $3.95. The total cost for the position is $94.95 per share ($91+$3.95). Again, let’s fast-forward to option expiration in September. If SPY is below $81 per share, you can exercise your option and sell your 100 shares for $81 per share (the strike price of the option). It doesn’t matter how far below $81 per share SPY is trading. The put option you own allows you to sell your shares at $81. The break-even price for this particular example is $94.95 per share. That means SPY must increase by 4.34%, which covers the cost of the option, for you to break even. For some investors, that’s a small price to pay in exchange for downside protection.
There are many more ways to incorporate options and ETFs into your portfolio. As these two examples show, options on ETFs allow investors to incorporate various strategies that allow them to control the potential risk and return of investing.
For millions of investors, options offer a powerful way to build better portfolios. ETFs offer investors the ability to use option, while traditional mutual funds do not. This is another reason why so many investors are shifting dollars to ETFs and away from mutual funds.
