As people become familiar with the exchange traded fund investment vehicle, traders are taking old tricks and applying it to ETFs. The more sophisticated investor is utilizing options to capitalize on short-term fluctuations and also to hedge.
Options are a type of financial instrument that allow the trader the opportunity to buy (“call”) or or sell (“put”) a security at an agreed-upon price – the strike price – to a specific date, or the exercise date. The later the expiry date, the higher the cost of the option.
It is less capital intensive to purchase an option, writes Cory Mitchell for ETF Database. The option only captures fluctuations in the price of an ETF, so it may sell for for as low as a $1 per share – this price is known as the “option premium.”
The call options allow traders the opportunity to buy at a certain price and the put option lets the trader to sell at a certain time. A trader would want stocks to rise for a call option or fall for a put.
For example, if you think “X” ETF, which trades at $100, will rise over the next month, you would buy a call option with a strike price of $100 and a one month expiry date. For the same example, if the call option costs $1 per share, you would want “X” ETF to rise above $101 to generate a profit. Traders can also sell the option before the expiry date to lock in profits before expiry. However, if the price of the ETF falls, traders would allow the option to expire worthless, in which case the trader would only lose the amount paid for the option, or try to sell before the expiry to minimize losses.
Traders can also sell a call option, or “write” a call option. In this scenario, you are allowing someone else the right to buy the ETF at a specified price and within a certain time, and you would receive the option premium paid by the buyer. If you don’t own the ETF, which is also known as “naked” call writing, you face significant losses if the price increases. If you own the ETF and write a call option, or a “covered” call writing, then the risk is limited. In a rising market, a trader’s profit is limited, but potential losses in a declining market are partially offset by the option premium received.
When buying a put option, a trader anticipates a drop in prices. For example, if you think “Y” ETF, which trades at $50, will fall over the next month, you would buy a put option. If the put option costs $1, the ETF would have to drop below $49 to generate a profit in this example. If you allow the option to expire, potential losses are limited to the cost of the option premium. Potential profits are not unlimited since it can only drop to $0.
Traders who write put options give someone else the right to sell the ETF at a specific price within a certain period in exchange for the option premium. Again, if you are not short the ETF, you are will write a “naked” put, which could result in huge losses. If the price rises, the premium helps offset losses on your short position. On the other hand, if the price declines, the trader only profits up to the point the buyer exercises their right to sell.
Paul Weisbruch at Street One Financial, who writes the “ETF Chart of the Day” series, also often discusses call/put activity in ETF options to get a handle on sentiment for various sectors. [Investors, Options Traders Turn Bearish on Small-Cap ETFs]
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.