What is an Option?
When you buy a call option on an ETF, you are buying the right to acquire the ETF at a predetermined price within a set time period.
For example, if you buy a call option on an ETF with a strike price of $20, you get the right to buy the ETF for $20 during the life of the option. If the price of the ETF moves above $20 during that time period, you can either sell the option or exercise it for a profit (after covering the cost of the option).
If the price stays flat or moves down, you have no obligation to exercise the option and it expires worthless. You are only out the cost of the option.
Put options work in a similar fashion giving buyers the right to sell an ETF at a preset price in the future.
Using ETF Options in Your Portfolio
Options strategies can get pretty complex, but there are a couple of straight-forward ways for investors to use ETF options to fine-tune their portfolio management.
One use of options is as insurance. For example, if you have a long position in an ETF, you could buy put options as insurance which would payoff in case the value of the ETF declines. The number of put options, the strike price and the time period all depend on how much insurance you want. Remember, just as in real insurance, the cost of the premiums eat into your profits.
Another way to use options is as leverage. The idea is that you buy the option instead of the ETF. Since options are typically priced at a fraction of the price of the underlying ETF, you can buy many more of them for the same amount of money.
Two caveats here – first, remember that options have a limited life span. If the price of the underlying ETF does not move, you can lose your entire investment. Second, leverage magnifies your gains if you’re right, but also magnifies your losses if you’re wrong.
Options As Information
Another way to use options is to study their trading behavior and look for changes as a barometer of future trends.
A recent example is mentioned in the WSJ article “With a Bear Market Near, Options Traders Embrace It” which discusses how traders are behaving in a way that indicates that they are anticipating a bear market.
According to the article, on March 7 traders were buying call options on ProShares UltraShort S&P 500 (Amex: SDS). Since the UltraShort ETF moves in the opposite direction of the S&P 500 index, traders were betting that the market will continue to move down.
Insight from the options trading comes from looking at the ratio of calls and puts. On March 7, 19,000 calls on SDS were traded while only 2,500 puts changed hands. The large call activity and small put activity indicates a bearish outlook.
Read more about SDS on ProShares website.
Seek guidance from your financial advisor before investing in ETFs or options.