Using Options Strategies With ETFs

Sell Call – If a security remains below the call strike price prior to expiration, the ETF holder keeps all of the income generated and realizes the price return from the underlying ETF. The primary risk with selling calls is if the ETF rises above the call price, the opportunity for upside return is capped.

Sell Put – Selling a put will generate income immediately. In this scenario, the seller does not hold the underlying ETF but will need to purchase the ETF from the put buyer if the ETF price falls below the strike price. As long as the ETF price stays above the strike price, there is no need to purchase the underlying ETF and the seller banks extra income to his/her portfolio.

These basic option strategies are just a sampling of techniques that can enhance an ETF portfolio's opportunities. Individuals may also buy calls to speculate that an ETF will rise in value with a small amount of money. Hedge funds will often employ this leveraging technique. Collars, condors, butterflies, and calendars are more complex strategies that help manage risk or generate income in the portfolio.

A few key factors must be considered when implementing an options strategy with an ETF portfolio: liquidity, volatility and risk.

Liquidity

More than 500 ETFs have open interest on the Chicago Board Options Exchange. However, only eight ETFs have traded an average daily volume above 100,000 option contracts in the past 20 days, and 39 have traded above 10,000. Liquidity is best for very broad-based ETFs with large assets under management and large ETFs that offer significant volatility. SPY, the SPDR S&P 500 ETF, offers by far the largest option volume of any ETF. Volatility

Volatility is key to generating option activity and obtaining premiums on income generation. Since 1990, the VIX index has ranged from 10.4% to almost 60%. Volatility peaked in late 2008 when equity markets plunged during the financial crisis. When volatility is high, option activity picks up because investors are interested in hedging their portfolios and desire low-cost opportunities to profit in market swings.      

Risk

A covered-call strategy offers the lowest risk because it does not require leverage to implement. However, even though the downside price movement is cushioned by income, there is nothing to stop the ETF price from plunging in the portfolio.

Inverse ETFs can also offer liquidity in the option market. Traditional individual stock portfolios with an option strategy may be quite risky as they are fully exposed to the equity market. By integrating inverse ETFs with an option strategy, overall exposure to the equity market may be hedged while generating additional income in the portfolio.

There are many ways to enhance a traditional, diversified portfolio. With an ETF portfolio, options are another way that investors may seek returns. The strategies outlined above may be implemented by individual investors and professionals alike.  As with any options strategy, take caution in understanding the risks and rewards.