Exchange traded funds (ETFs) are useful investment tools and trading options on ETFs is one of the many ways you can maximize the benefits of them.
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.