Using Options on ETFs

by: Tom Lydon

We felt we would share some information from a recent dialogue about ETFs and their use with options. Josh Inglis of optionsXpress provides an overview of options and ETFs. This investment strategy may not be for the average investor, however it is another way ETFs can play a role in a more sophisticated asset allocation:

Because ETFs trade just like stocks, anything you may have read in the past about how options are used and what benefits they can offer to stock investors extends to options on ETFs. There are three main ways investors use options: 1) protect portfolios, 2) generate income and 3) enhance returns.

Investors protect portfolios with “put” options, the value of which goes up in value as a stock or ETF price goes down. People often buy puts as a form of insurance, as it gives them a price floor for their stock or ETF.

One common income generation strategy is the covered call. In this strategy, an investor holds an underlying stock or ETF, and then sells “calls” against it. This is typically used on longer-term holdings which are sideways movers.

For enhanced returns, the simplest strategy would be to buy call options, the value of which go up as the stock/ETF price goes up. The reason this enhances returns is that it requires much less capital to control the same number of - or more - shares. Using (NYSEARCA:IWM), a popular ETF option, as an example. An investor could pay about $8100 to buy 100 shares, or just $470 to control the same number of shares. The remaining capital could be put into fixed income, or turned to other trading opportunities.

Yes, one of the risks about options is that they eventually expire – if time runs out those options ultimately can become worthless (although most investors have loss limits and would close out a position long before that would happen). And for those investors more comfortable with a longer time horizon, some options allow investors to go 1, 2 or 3 years out. Those options are more expensive, but still are much less costly in terms of capital at risk than outright stock ownership. An IWM option expiring in January 2009 would cost about $1100. That leaves an investor a lot more time to be right.

Also, here’s a list of optionable ETFs – it’s quite lengthy as you’ll see.