Trading options on ETFs could potentially allow traders to use the leverage of derivative markets to increase gains from ETF trades, writes David Penn for Yahoo! Finance. It should be noted that not all ETFs have liquid options, which means most investors should stick with more widely-traded index ETFs and liquid country ETFs.

Calls are options used when the prices are thought to be heading higher – they give an investor the right, but not the obligation, to buy a stock at a pre-set price.In other words, you’re “reserving” today’s prices for an item that you think may be priced higher at a future date.

Penn says the basic options strategy for ETF traders is buying deep in the money calls with long signals in ETFs, or buying deep in the money puts to fulfill short ETF signals. Let’s translate that.

“Deep in the money” refers to calls that have a strike price that is 2 or 3 strike prices below the current price of an ETF. As an example, if an ETF were priced at $44 and a long signal on the close was received, a deep in the money call would be a call with a strike price of $40 or even $35.

With short ETF signals, traders may use puts if prices are thought to head lower and increase in value as the markets abate. Buying puts deep in the money is a way to use puts on overbought ETFs.

Why would an investor want deep in the money options? Deep in the money options are more likely to closely track an underlying asset whereas out of the money options could be subject to major impacts as a result of adverse price movements in the underlying asset. If the underlying recuperates or closes profitably, a deep out of the money option may not recover as much.

Be aware: while they have benefits, options also have risks, and investors are wise to be aware of them..

Active traders are using ETFs to hedge against swings in the markets, remarks Kirk Shinkle for U.S. News. Shinkle particularly notes popular hedging strategies that include:

• Coverd call or buy/writes strategies. This strategy is said to be no riskier than trading in the underlying ETF, but with the added bonus of extra earning power in times of a slower market.
• Protective puts. It is a type of trading insurance policy where if you buy a protective put for every 100 or so shares of an ETF, you will limit potential downside risks.
• The “naked put.” This could allow a trader to earn some returns in volatile markets. A trader would agree to buy more shares of a fund if the index drops below a set price, but premiums earned are often higher. It should be noted that if shares fall below the price of the put then you must have enough capital to buy the number of shares.
• Index risks. An investor can offset risk in sectors of a broad-based fund by shorting sectors that show weakness within the index.
• Leveraging. Leveraged ETFs should not be used as a hedge because they lose their effectiveness the longer the ETF is held. Returns on leveraged ETFs can be reduced in medium- or long-term investment as a result of market volatility.

Max Chen contributed to this article.

1. PowerShares S&P BuyWrite Portfolio (PBP): This ETF is meant for tracking the CBOE S&P 500 BuyWrite Index, which measures the rate of return of an S&P 500 covered call strategy. This strategy consists of holding a portfolio indexed to the S&P 500, and selling a series of call options, each with an exercise price at or above the current level of the S&P 500. The downside risk is hedged and the upside is limited. Why would you use covered calls? Investopedia notes that it’s often done when an investor has a short-term neutral view on the asset, and the strategy is also known as “buy-write.” 888Options also states that this would be used when an investor feels that a fund’s market value will see little range over the lifetime of the call contract.

2. ELEMENTS S&P CTI ETN (LSC): This exchange traded note (ETN) is linked to the S&P Commodity Trends Indicator, which applies a long/short strategy to 6 commodity sectors. This index takes long, short, or flat positions in each commodity based on the exponential average of the prices over the past seven months. In March, Claymore filed with the Securities and Exchange Commission (SEC) for an ETF based on this index.

3. SPDR Barclays Capital Mortgage Backed Bond ETF (MBG): MBG invests in investment-grade mortgage bonds, holds 14 securities, tracks 1,700 components and charges an expense ratio of 0.20%. The fund tracks the Barclays Capital U.S. MBS Index, which covers investment grade, U.S. agency mortgage-backed securities.

4. iPath Optimized Currency Carry ETN (ICI): Another ETN, this strategy is a play on the carry trade. It uses objective and systematic methodologies to capture returns available by investing in high-yielding currencies with the exposure financed by borrowings in low-yielding currencies. ICI is able to invest in currencies of the G10 countries, including the U.S. dollar, Japanese yen and the Australian dollar.

5. MacroShares $100 Oil Up (UOY) and $100 Oil Down (DOY): Issued in pairs, these ETFs (which are actually trusts) allow investors exposure to either upward or downward movements in light sweet crude oil futures contracts. As oil moves up or down, a corresponding dollar amount is transferred between the trusts – for example, if oil moves up $1, then $1 is moved to the up fund and taken from the down fund. Just as their predecessors had been, UOY and DOY are paired products that track the price movements of West Texas intermediate oil. The starting price for a share is $25, representing one-quarter of the benchmark oil price. As the price rises and falls, assets are
transferred back and forth dollar-for-dollar between the Up and Down trusts. The termination trigger for the new funds is $185 a barrel.

Covered calls are an options strategy in which an investor holds a long position in an asset, then sells call options on the same asset in order to generate increased income.

Why would you do it? Investopedia notes that it’s often done when an investor has a short-term neutral view on the asset, and the strategy is also known as “buy-write.” 888Options also states that this would be used when an investor feels that a fund’s market value will see little range over the lifetime of the call contract.

One ETF that employs such a strategy is the PowerShares S&P 500 BuyWrite (PBP), which is down 11% year-to-date.

But if you want to use the buy-write strategy with other ETFs, Larry Connors for Trading Markets explains how you can. Please note that this example is purely hypothetical, and these are not recommendations.

If you’re bullish on financials, you might want the Ultra Financials ProShares (UYG), which is designed to give twice the daily performance of the Dow Jones U.S. Financials Index. Connors notes that the fund is a diversified mix of bank, brokerage, insurance and real estate stocks, and unless all those industries are nationalized, it’s next to unlikely that UYG would go to zero.

On Friday, UYG closed at $2.20, and June 3 calls were selling for 50 cents. This means that you could by UYG at $2.20 and take in more than 20% of premium for a less than four month call.

If the fund climbs above $3 by June, the return to call is $1.30 – a better than 50% return after costs. The annualized return is 150%.

If UYG is under $3 by that date, you will get the chance to sell the out the money (OTM) calls again, maybe at another premium.

The risk in this strategy is that the fund’s price could decline, however, giving the investor a substantial loss.

A popular investment strategy, known as “buy-write,” involves the purchase of stocks and sale of options. The strategy has created the highest premium in two decades, reports Tennille Tracy for The Wall Street Journal. The monthly premium gross for November was 8.1% – the highest percentage on record since 1988.

By utilizing buy-write strategies, people in the markets are able to sell calls that would have expired worthless. Calls is essentially the right to buy a stock at a fixed price.

These transactions engender lucrative premiums because price of options are in part determined by volatility in stock markets. One such ETF that may benefit from the premiums generated in options writing is PowerShares S&P 500 BuyWrite (PBP), which is down 32.3% year-to-date.

A BuyWrite fund is a strategy that has been most commonly utilized by institutional investors. The method allows investors to buy a basket of stocks and then write covered call options on the holdings, explains Eric Rosenbaum for Index Universe.

During periods of flat or negative returns, BuyWrite funds tend to smooth volatility, while allowing investors to pick up some income from options premiums. The reason the funds weren’t as popular in recent markets is that during a bull run, the strategy can limit upside potential.

In essence, as BuyWrite strategy is considered conservative, as a writing options contract is involved and therefore, do not appeal to the masses. Investors that use this strategy say that the actual “smoothing” effect will be seen over a long period of time, to actually see the benefits. The major benefit comes from the premium generated from options writing.

PowerShares S&P 500 BuyWrite (PBP) is down 29.6% year-to-date.