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.