As with equities and indexes, there are many exchange-traded funds (ETFs) that list options. And while there are many derivative strategies to utilize in conjunction with ETFs, here are four basic ways to use options. Whether you are looking for temporary exposure to a certain sector or want to hedge current ETF positions in your portfolio, an ETF option might be the perfect asset for your investment strategy.
- There are four basic strategies when using ETF options: buying calls, selling calls, buying puts, or selling puts.
- While the price of each call option will vary depending on the current price of the underlying ETF, you can protect yourself or expose yourself to upside by purchasing a call.
- Selling options is a more advanced trading strategy than buying options.
- Selling options carries more risk than buying options.
Buying Call Options
A call option is the right to purchase stock, or in this case, an ETF. Up until the expiration date of the call, you have the right to buy the underlying ETF at a certain price, known as the strike price.
For example, if you buy the Dec 80 OIH call (Oil ETF), you have the right to buy that ETF for $80 at any time up until the third Friday in December. So if the OIH is trading at $90, you can buy it at $80. However, if the OIH never gets above $80 before December, your call will expire worthless. You wouldn’t exercise the right to buy the ETF at $80 when you can actually buy it for less than that.
While the price of each call option will vary depending on the current price of the underlying ETF, you can protect or expose yourself to upside by purchasing a call. To break even on the long call trade, you just have to have the ETF rise above the strike price and the purchase price of the call you bought. So if you buy the Dec 80 call for $2, you need the ETF to climb above $82 to break even. Anything over $82 is profit. If the ETF never gets above $80, your loss would be $2 for every call you bought.
Selling Call Options
When you sell a call, you take the opposite position of a call buyer. You want the ETF to go down. Using our example, if you sell the Dec 80 call for $2, you will make $2 on every call if the ETF price never rises above $80. However, if the ETF does climb above the break-even point of $82, you are liable to sell the ETF at $80 to the call owner and incur the loss.
Selling options is a more advanced trading strategy than buying options. When purchasing options, the maximum risk is the purchase price, and the profit is unlimited to the upside. However, when selling an option, the maximum profit is the sale price, and the risk is unlimited. An investor should be very careful and very educated before selling options.
Buying Put Options
There is a safer way to gain exposure or hedge the downside of an ETF than selling call options. If you think an ETF will decline in value, or if you want to protect downside risk, buying put options might be the way to go. A put option is the right to sell an ETF at a certain price. Using our example, if you buy the Dec 80 put, you will have the right to sell the underlying ETF for $80 at any time before December. If the ETF trades at $75 anytime before December, you can sell it at $80 and profit on the difference in price. If the ETF stays above $80, then your put will expire worthless. You wouldn’t sell the ETF at $80 if it is trading at a higher price.
Again, you have to factor the purchase price into your equation. If the Dec 80 put is bought for $4, then your break-even point is $76 ($80-$4). So if the ETF is trading at $75, and you exercise your right to sell it at $80, you would make $1 on every option you bought. If the ETF never dips below $80 before the put expires in December, your loss would be the $4 purchase price for every option.
Selling Put Options
When you sell put options, you give the right to the put buyer to sell the ETF at the strike price at any time before expiration. That is the opposite position of purchasing puts, but similar to buying calls. You want the ETF to rise or stay above the strike price.
Using our example, if you sell the Dec 80 put for $4, you never want the ETF to go below $80 before the put expires in December, or at least not below the break-even point of $76. If that holds true, you would profit $4 on every put you sell. However, if the ETF drops below the break-even price, you would start to incur losses on every put that is exercised.
Again, it is important to note that selling options brings more risk than buying options. That is not to say it isn’t potentially profitable. The cost of that risk is factored into the price of an option. But if you are a beginner in the world of calls and puts, buying ETF options is the safer route.
The Bottom Line
While there are many more ways to incorporate ETF option strategies into your portfolio, these are the basics of trading ETF derivatives. Once you feel comfortable with the foundations of options trading, only then should you consider more intermediate or complex trading strategies like straddles and volatility arbitrage.