Best Option Strategies for ETFs
An ETF is a perfect asset that you can use to improve your overall investment strategy. It can be used in two different ways to affect the overall performance of your portfolio. Firstly, you can use ETFs to achieve temporary exposure to a specific investment sector. Secondly, you can use them to hedge current positions in your portfolio.
Just like equities and indexes, there is a variety of ETFs that list down options. Moreover, there are some derivative strategies which can be used alongside ETFs. Out of these, here are four basic strategies that can be followed to utilize options.
Purchasing a Call Option
A call option is a right to buy an ETF or a stock in some company. Every call option has an expiration date. For as long as the call is active, it gives you the right to buy an ETF of your choice at a specific cost that is known as a strike price.
For example, if you purchase the Dec 80 OIH call (Oil ETF), it gives you the right to buy that specific ETF for $80 at any time until the third Friday of December. This means that if the OIH is trading at $90, you can purchase it at $80. This gives you the chance to save $10 on the purchase price.
Unfortunately, the ETF may never rise in value above $80 before the third Friday of December. If this happens, then your call option will expire in a worthless way. Normally, you wouldn’t exercise the right to buy an ETF at $80 when you can wait and buy it for less than that price.
The price of every call option usually changes. This is dependent on the price of the underlying ETF. Generally, when you buy a call, you can protect or expose your upside.
For you to break even when buying a call option on a long trade, you simply hope that the Exchange Traded Fund (ETF) increases above the strike and purchase price of the call that you bought. Therefore, if you but the December 80 call option at $2, you hope that the ETF will climb above $82 for you to break even.
Any extra money which is made above $82 is regarded as profit on the purchase. On the other hand, if the ETF does not rise above $80, then you experience a loss of $2 for every call option that you bought.
Selling a Call Option
During the sale of a call, you are now on the other side of a trade with a call buyer. Your hope is that the ETF reduces in value. By referring to the example described above, if you sell the Dec 80 call option for $2, you will make $2 on every call if the underlying ETF price does not rise above $80.
Incidentally, if the ETF actually increases in value above the break even point of $82, then you have to sell the ETF at $80 to the owner of the call option. This causes you to suffer the loss.
Selling call options is generally an advanced strategy than purchasing options. During the purchase of options, the most risk that you incur is the purchase price. Moreover, the profit is unlimited to the upside. On the other hand, when you are selling an option, the maximum profit is the sale price while the risk is virtually unlimited. Therefore, an investor should exercise caution and perform enough research before selling options.
Buying a Put Option
if you want to hedge the downside of an ETF or gain exposure for your portfolio, there is a safer way to do this than selling a call option. If you are convinced that an ETF will reduce in value or you are interested in protecting the downside risk, purchasing a put option is a good strategy.
A put option gives you the right to sell an Exchange Traded Fund (ETF) at a specific price. Once again referring to the example described above, if you purchase a Dec 80 put option, you automatically have the right to sell the underlying ETF for $80 at any time before December.
This means that if the ETF trades at $75 at any time before December, you can sell it at $80 and get a profit of $5. However, if the ETF price stays above $80, then your put option will expire worthlessly. This is because you can’t sell the ETF at $80 if it is trading at a higher price in the market.
While buying a put option, you have to consider the purchase price. If you buy the Dec 80 put option at $4, your break-even point becomes $76. This is a result of its $80 value minus your purchase price of $4.
As such, if the ETF trades at $75 and you sell it at $80, you will make $1 for every option that you purchased. On the other hand, if the ETF does not reduce in price below $80 before your put option expires in December, then your loss will be the $4 buying price for every option.
Selling a Put Option
Whenever you sell a put option, you give its buyer a right to sell the ETF at the strike price at any time before its expiration. This is actually the opposite of buying a put option. However, it is the same as buying a call option. When you sell a put option, you want the ETF to increase in value or simply stay above its strike price.
Referring once more to the example above, if you sell the Dec 80 put option for $4, your objective is that the ETF does not go below $80 before the put option expires in December. At the very least, it should not go below the break-even point of $76. If your objective holds true, then you make a profit of $4 on every put option which you sell.
Should the ETF drop in value below the break-even price, you will begin to incur losses on every put option that is exercised.
While selling options has more risk than buying them, it is actually a profitable strategy. The cost of selling options is included in their prices. However, if you are only a beginner in the industry of call and put options, simply buying ETF options is the safe way to invest.
Final Thoughts
There exists a collection of other ways in which you can include strategies of ETF options in your portfolio. However, the ones indicated above are the fundamental ones of trading ETF derivatives. After you get a firm understanding of the foundations of trading options, then you can move on to intermediate level and complicated strategies. Examples of these are volatility arbitrage and straddles. In the world of Exchange Traded Funds (ETFs), you should crawl before you walk.