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'Safe' options: ETFs a good platform for their use

Gallery:Step 1|Step 1: Active Investors

Investors believe options are risky, and rightly so when they are used alone. But they take on a new light when an investor already owns an asset being optioned. ETF investors in particular can exploit their use to protect their holdings in an entirely conservative manner.

Want to lock in profits from a recent run-up in an ETF without selling the position and triggering taxes? Want to buy insurance against a drop in a shaky market? These and other defensive strategies can be obtained with the nearly 70 ETF options currently available. Although many large stocks offer options, trying to engage in many at once becomes a nightmare of expense, tracking and paperwork. ETFs make defensive options easy.

Options are the right to buy (called a call) or to sell (called a put) a stock at a certain price before a certain date. These rights have value and are themselves bought and sold on stock exchanges at prices that reflect the fortunes of the underlying asset and the time left in the contract.

A call is normally speculative because the option can expire as worthless for the buyer or the option may shoot up dramatically and expose the seller to huge losses. Selling calls when the investor is "covered", or owns the underlying ETF, is inherently conservative, on the other hand. It can be likened to the farmer selling his wheat harvest in July even though harvest does not occur until October. It is a time-honored and reasonable practice. The seller is pocketing the option cash as a way to lock in profit or to insure against mild loss. Selling uncovered calls, however, exposes the seller to unlimited risk since there is no way to know how high the underlying stock could rise. The following table shows some outcomes for a typical covered call sold for $10 for a strike price of the underlying ETF at $110 in a year's time, while assuming the ETF is currently trading at $100:

 

ETF at Expiration Profit/Loss calculation Difference from no action
$130 $10 ETF gain (ETF called at $110) $10 option income= $20 -$10 since no action would have led to $30 ETF gain
$120 $10 ETF gain (ETF called at $110) $10 option income= $20 break even since no action would have led to $20 gain
$110 $10 ETF gain $10 option income=$20 $10 since no action would have led to $10 ETF gain
$100 No ETF gain $10 option income=$10 $10 since no action would have led to no ETF gain

 

 

The difference between adopting this strategy and doing nothing depends upon just how high the ETF will rise before the expiration date. If fails to climb by more than the amount of the option income, then the strategy puts another $10 in the investor's pocket. That's an extra 10% return in the case of the ETF remaining flat or 10% cushion against decline. The covered call is well suited when the investor wants an income stream and is neither bullish nor bearish about a market.

The downside of covered calls is that the prospect of steady income can lure an investor into ignoring signs of severe downturn. If the investor is truly bearish, covered calls will offer only limited protection. Inversely, covered calls remove most of any sharp rise that may occur for the ETFs, so their owner gives up windfall profits, which made them unpopular in the boom years of the 1990s.

For deeper protection against loss, the options investor can purchase puts for an ETF they hold. This gives them the opportunity to unload the ETF if it drops below the strike price in time. Bought alone, the put is speculative because there is a chance that it will expire worthless, and sold alone exposes the investor to unlimited loss. Bought as an extension to an existing position in an ETF, the put's role changes to one of insurance.

The following table shows outcomes for a typical protective put bought for $10 for a strike price of $90 a year away:

 

ETF at Expiration Profit/Loss calculation Difference from no action
$100 no ETF loss - $10 option cost= -$10 -$10, cost of protective put
$90 $10 ETF loss -$10 option cost= -$20 -$10 since ETF alone would have lost $10
$80 $10 ETF loss (ETF put at $90) - $10 = -$20 None, since ETF alone would have lost $20
$70 $10 ETF loss (ETF put at $90) - $10 = -$20 $10, since ETF alone would have lost $30

 

 

Puts make sense if the ETF owner is concerned about serious loss for a short period of time. As with many investments, the price of an option is critical. They are often too expensive to be considered for repeated use. If an investor is truly bearish for the long-term, investors should consider selling out completely. Puts are best used opportunistically.

Transaction fees should be factored in, but in context they can be justified when the alternative of selling out an entire underlying position also generates fees. Tax considerations are also mixed. While income derived from them generally does not enjoy low long-term tax gain treatment, they can help investors avoid incurring capital gains from selling the underlying position.

Options will remain, however, another benefit of ETF ownership and an important, if occasional, tool when used in proper context.