MATT Hello, and thank you for joining us for a Graduate Seminar - ETF Options Strategies: Hedging Risk, Building Income, the 7th session in our 10 part ETF university series. My Name is Matt Hougan of ETF.com. I’m joined by Paul Britt, senior ETF specialist. Before we get started, I wanted to give a special thank you to Deutsche Asset & Wealth Management and MSCI for sponsoring the webinar series and helping to make the ETF University possible. To answer a question we’re often asked, ETF.com is solely responsible for the content of this webinar, which underscores the sponsors’ generosity. Before we get started, a little housekeeping and to answer a few questions up front we always get. Yes, a replay of this webinar will be available at ETF.com in the coming days. Also, if you’re interested in CE credits, anyone attending the live webinar will receive an email with instructions on how to register your CE credits tomorrow. We’ve had strong interactive participation in this series, and we want to keep it going. If you have questions during this presentation, you can fire them in in the Q & A window on your screen, and we’ll address as many as we can at the end.
Here’s the agenda…. We’ll first cover ETFs’ huge presence in the options space, and talk about the pros and cons of using options in today’s climate. Then we’ll take a step back for a quick refresher on options terms and concepts. That will set the table for the main event: a dive into specific strategies for generating income, and for hedging different kinds of risks. We’ll talk about how to trade options to put these strategies in play, and we’ll be sure to leave time for your questions. At this point I’ll hand it off to Paul
Options on ETFs radically reshape
risk and return scenarios on investable, relevant portfolios
ETF Options Strategies - Landscape
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BRITT Thanks Matt. Why are we here, talking about options on ETFs? Options – unique amng all securities—have the distinct ability to provide asymmetric return profiles relative to an underlying ETF. Their cost structure differs from other derivatives and securities too: money chnages hands at the outset, unlike futures and swaps, generally. In combination, these 2 aspects of options hints at their power to hedge, to earn income, to speculate and shape a risk and return scenario in almost limitless ways. That’ something that really isn’t possible with any other kind of security. Options on ETFs allow this power to be applied across the vast breadth of the investible universe. ETFs’ ability to provide both precise exposure to entire markets or asset classes or regions or single countries, bonds, commodities etc. helps top explain the huge popularity we see here. This power comes with costs and risk of its own of course. A with investing and life in general, you give something to get something. Forgoing upside to gain downside protection, or paying a premium directly or receiving a premium in return for carrying risk
Our focus here: Option ON ETFs – puts and calls on ETFs . There are a dozen or so ETFs that make use of options as part of their strategy. We’ll certainly touch on those too and use them as performance proxies when evaluating a particular strategy
ETF Options Strategies - Landscape Underlying for Most Liquid Options
SPY ETF SPX Index IWM ETF VIX Index QQQ ETF AAPL Stock FB Stock EEM ETF BAC Stock VXX ETF
“Have no Fear”, Olly Ludwig, ETF Report, July 2014
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Where do ETFs rank in the world of options? In shoirt, they’re huge. Here’s a list of the Top 10 optionable securities & indexes by trading volume. 3 of top 5 are ETFs. 5 of 10 are ETFs. Maybe you’re not using options on ETFs yet. But some other people sure are. What’s not on the list?
ETF Options Strategies - Landscape
ETFs Stocks Mutual Funds Indexes Optionable
Investable Portfolio
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Mutual funds… When it comes to portfolio exposure, ETF’s are sole choice to provide options exposure to an investible underlying. That makes them extremely well-suited for mixing and matching options and underlyings with no basis risk, when the underlying is a broad portfolio rather than a single stock. Still, an option on a broad market ETF, might still work to modify an existing position in a mutual fund to the extent the the underlying exposures align.
ETF Options Strategies - Landscape
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ETF Share of Total Options Volume (Year)
“Have no Fear”, Olly Ludwig, ETF Report, July 2014
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Looking at the larger options market, we see that ETFs are a large and growing chunk of total options trading volume – about a third of all options traded by volume in 2013, largely mirroring the growth in ETFs themeselves
As we narrow the focus to just ETFs, here’s a list of the top 10, using open interest on contracts as a guide. Note the breadth of underlying exposure – US equities, precious metals , broad emerging markets, single country and single sector equities
etf.com/EEM
ETF Options Strategies - Landscape
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Let’s be clear, Not every ETF has options traded on it. Over 500 of the 1600 + ETFs have options contracts written on them. That’s a lot, but it’s not complete. Further, the depth of the options market on the 500-plus ETFs varies too. You can find open interest by number of contracts on any ETF at ETF.com. Type into your browser: etf.com/ticker; go to tradability tab, lower right. Updated daily
• Income • Low rates favor options for income • Low volatility climate reduces
premiums • Hedging
• Equity risk while it’s “cheap” • Interest rate risk
ETF Options Strategies - Landscape
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Here’s our last “landscape” slide: and it touches on the current market climate with respect to using options for income and for hedging.. The two themes here are well known: low interest rates and low equity volatility Low yields have pushed investors into all kinds of spaces outside of bonds, including options,. Still, lower equity volatility can raise some challenges to this approach, namely lower premiums. We’ll dive into specifics shortly The flip side of low equity volatility is that the price of insurance is cheaper. For hedging to really work, investors need to buy protection before they need it. Trying to hedge IN a crisis is way too late, meaning too expenive. Equity risk isn’t the only risk out there to be hedged of course. For example, options on Treasury ETFs effectively target interest rate risk.
ETF Options Strategies - Refresher Call Put
Buy Right, but not obligation, to
buy at set price
Right, but not obligation, to
sell at set price
Sell or Write Obligation to sell at preset
price
Obligation to buy at preset
price
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Before we dive into specifics of how use ETF options for income & hedging, let’s brush up on options terms and concepts. I’ll move quickly here. The building blocks are calls and puts, and investors can take either side of a call or put. Buying a call gives you the option to buy the underlying ETF at a set price, called the strike price. Calls gain in value when the price of the underlying ETF rises. Buying a put gives you the ability to sell the ETF at a set price. Puts gain in value when the price of the underlying ETF falls. Investors can, with equal ease, take the opposite side of these trades, and instead of buying the option, can sell or write the option. Investors earn immediate income by selling the option, and in return, bear the risk of losing money when the ETF price rises for calls and falls for puts.
ETF Options Strategies - Refresher
Call: Buy
Bloomberg 8/11/2014
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“Hocket stick” Diagrams like these help keep things straight. The horizontal axis shows the price of the underlying ETF.; the vertical axis is the profit or loss from the strategy. Note the asymmetric shape we reffered to earlier. For a long call, that means the upside when the underlying ETF price rises, but the downside is radically flattened. The downside here comes from the premium paid for the option, and the difference between the strike price of the option and spot price of the ETF
ETF Options Strategies - Refresher
Put: Buy
Bloomberg 8/11/2014
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A long put has upside when the price of the underlying ETF falls
ETF Options Strategies - Refresher
Call: Sell or Write
Bloomberg 8/11/2014
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The short side of the call means you lose out when the ETF price rises. In retirn, you earn the income from selling the option, betting that it will expire before the ETF price rises
ETF Options Strategies - Refresher
Put: Sell or Write
Bloomberg 8/11/2014
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Writing a put means you earn the premium but are on the hook for drops in ETF prices. Each individual option has many variables which affect performance. Investors can choose among some of the these variables, such as strike price and time to expiration to shape the desired outcome. Just as important: Puts and calls, long and short, are building blocks. They’re are often combined with underling positions in the ETF itself, or with other options, or with existing parts of a portfolio offfering incredible flexibility.
Option Price
ETF Options Strategies - Refresher
Intrinsic Value
Time Value
• ETF Price • Strike Price
• Volatility • Interest
Rate • Time to
Expiry Fundamentals of Futures and Options ( a summary), Roger G. Clark, , Year in Review, CFA Institute Research Foundation
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Options aren’t free. Money changes hands at the outset when contract is entered. How much money? The inputs to the option price include the price of the underlying ETF, and the strike price, which is the agreed-upon price at which the stock might be bought or sold. The ETF’s spot price and the strike price are part of the option’s intrinsic value. The option price has a time value too . The most obvious input here is the time until the option expires. Options have a finite life, like a T-bill. The volatility of the underlying ETF is an input too since a more volatile ETF might move in or out of the money in the time that’s left. Interest rates also matter (to a smaller degree these days) to factor in what your money could be earning if it wasn’t tied up in an option These inputs and the math that relates them are part of the Nobel prize-winning Black Scholes pricing model. No need to dive into the math here, but the inputs are important to keep in mind. Note that investors can choose among options with different strikes and times to maturity, but take what’s given with respect to volatilty and interest rates. There are other pricing models too. Supply and demand, liquidity will also affect the price paid or received for an option.
ETF Options Strategies - Refresher Long call Long put
Security price (delta) Positive Negative
Time decay (theta) Negative Negative
Volatility (vega) Positive Positive
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Inputs to options prices are not static of course, and how they change drives how the price of the option change. It’s helpful to keep the direction or sign of that change in mind when working with options. The sensitivity of the option price to changes in the price of the underlying is called the delta, and its positive for calls and negatives for puts, assuming you’re long these options. If stock price goes up, a call will be worth more, but a put will be worth less. We’ll talk more about delta shortly. Time is not on your side if you hold an option, whether a put or a call. The value erodes as time passes, with some exceptions. An option with more time to expiry will be worth more than one with less time to expiry. Conversely, a more volatile underlying ETF equates to a more expensive option. The value of a long option position will increase as vol increases. That’s part of what makes hedging expensive if you try to buy in a downturn, but more valuable if you’ve acted before you need it.
ETF Options Strategies - Refresher SPY Call $4.52
In the Money Underlying 194.53 Strike 190.00 Time to Expiry 11 days Delta 82.8
SPY Call $0.04 Out of the Money Underlying 194.53 Strike 200.00 Time to Expiry 11 days Delta 5.1
Bloomberg 8/11/2014
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Just another point or two on delta. Delta is an expression of “moneyness”. Top table: the SPY call is in the money, by a lot. In the money means the strike price is less than underlying price. “By a lot” means 82.8 out of 100. The strong positive delta here means the price of the option will move in close proportion (83%) to the price of the underlying ETF. Why not 100% even though it’s in the money? Because there’s still time – 11 days to expiry, and the chance that it could move out of the money. Bottom table: Out of the money call – the strike price is greater than underlying price. Delta is very low, so price of option won’t be very sensitive to change in SPY price Note the options prices in this snapshot in upper right of each table: High for the in-the money, high delta call; low for the out-of the money, low delta call
ETF Options Strategies - Refresher SPY Put $6.00
In the Money Underlying 194.53 Strike 200.00 Time to Expiry 11 days Delta -85.0
SPY Put $0.09 Out of the Money Underlying 194.53 Strike 180.00 Time to Expiry 11 days Delta -2.9
Bloomberg 8/11/2014
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For puts, Delta is always negative: the option price moves in oppostite direction of underlying share price, by design . In this case, if SPY goes down, the price of option goes up. Top table: the put is in the money since underlying price (SPY) is less than strike. Delta is large and negative, so the option price will drop proportionally with increases in share price. The option carries a high premium. Bottom table – underlying is greater than strike. Delta is negative but very small. Option price is not very sensitive to chnages in underlying price right now, and the premium is small.
• Mix and match on same underlying • Puts and calls • Long and short • Strikes • Dates
ETF Options Strategies - Refresher
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Last refresher slide: The power of options comes from ability to combine options and or the underlying to construct desired outcome. To be clear, no combination yields profit all the time. We’ll talk now about combining the components to meet specific objectives, income and hedging. We’ll cover income first
• Why Options for Income? • Alternative to Fixed Income • Lower Risk than Equity Income • Blood from a Stone • Popular & Tested Strategies
ETF Options Strategies - Income
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Why options for income? First, The low rate environment for bonds scarely needs repeating. The source of income for options strategies is in selling options and earning the premiums, typically in combination with another asset to offset some of the risk. Second, Such strategies deliver income with risk less than some equity-income strategies. Certainly the risk profile is different, whch improves diversification. Third, and Most interesting perhaps is the use of options to squeeze income from assets that don’t inherently kick off cash flows, like gold and silver, or to a lesser extent, from securities not typically associated with income, like the tech stocks found in the Nasdaq-100 ETF QQQ. Fourth, Income strategies like covered calls are well known and broadly adopted. That doesn’t mean that they guarantee fabulous performance, but the point is that there’s broad acceptance—and a track record.
• Covered call or buy-write: • Short call + long underlying • Earn premium • Forego some upside; almost full
downside • Fully collateralized
ETF Options Strategies - Income
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Here are the nuts and bolts of the covered call strategy, also known as a buy-write. You sell the call option to earn the income. You combine this position with equal nominal exposure to the underlying ETF, You give up some upside, and carry almost all the downside, offset by the premium you receive at the outset. The position is fully collateralized by the long underlying.
ETF Options Strategies - Refresher
Call: Sell or Write
Bloomberg 8/11/2014
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Here’s the a reminder of the short call position on its own. A long position in the underlying ETF would be a striaght upsloping line, so when you put them together you get
ETF Options Strategies - Income
Covered Call
Bloomberg 8/11/2014
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This. You earn income from the premium. You want the underlying ETF to go up in price so the call you’ve sold expires worthless to the long holder. In return for receiving the premium, but you give up some upside and you still carry downside risk. One way to think of the risk is to consider adding the option overlay to an existing position. Let’s say you already own SPY. By selling a call on it, do you add downside risk? No, since you already have downside risk. In fact you take a bit of downside risk away by adding in a certain premium. You do add the risk of not participating fully in the upside. So you’re modifying your risk, radically changing the shape. I hasten to point out that the hockey stick charts are helpful to keep the broad contours in mind, but they’re rough guidelines. Recall the delta numbers we looked at before, and how they’re not binary 0 or 100 or -100. The idea is that these diagrams in reality don’t bend in a sharp crease, but curve, and the delta is the estimate of that curve, the first derivative.
• Covered call: Earn income from non-traditional sources • QQQ • GLD • SLV
ETF Options Strategies - Income
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Repeating the blood from a stone theme: you can squeeze income from ETFs that typicvally don’t kick off much, like QQQ, or from ETFs that don’t kick off any, like GLD and SLV.
ETF Options Strategies - Income
Covered Call
Bloomberg 8/18/2014
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Here’s a quick snap shot of bulding blocks and their inputs. I’m using bloomberg here but here are plenty of options calculators out there, including at CBOE.com Very easy to change the variables. At top we see the underlying – the gold ETF, GLD In the lower right column we see the long position in the ETF, with a spot price of 125.035 In the left side column, we see the the call option, that we’re selling or writing. The strike is 129, so it’s out of the money. By selecting different strike prices and or time to expiratiion, you can dial in the size of the premium received along with the relative risk of the position moving against you. If you already own GLD, overlay the short option, using the convention of 1 option contract = 100 shares of the underlying ETF
ETF Options Strategies - Income
Strategy ETF 12 mo Yield Lg Cap Equity - Covered Call PBP 6.9% Lg Cap Equity SPY 1.9%
Gold - Covered Call GLDI 12.6% Gold GLD 0.0%
Bloomberg data as of 8/11/2014
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As we said, covered calls aren’t new; they have a track record. STill, the variables to the implementation of the strategy are many. It’s hard to assess every combination. SO – as a proxy for perfromance, let’s look at off-the-shelf ETFs that execute covered call strategies on a consistent basis. These ETFs PBP and GLDI are doing EXACTLY what we just described: writing the calls and going long the underlying. PBP is a covered call strategy that uses S&P 500 stocks as underlying. The 12 month trail distribution yield as of last week is 6.9% - handily beating SPY’s 1.9%. These are real world distibutions from the ETFs, net of fees. Even more striking: A gold covered call strategy GLDI: It cranks out a juicy 12.6% yield while the yellow metal itself of course has no yield whatsoever. Thinking back to the refresher slides, option prices increase with volatility, and gold is volatile, so covered call strategies on volatile gold earn higher premiums As a footnote, I’ll flash up the full names of these and other options-based ETFs at the end. The point of this perfromance snapshot, is this: Covered call strategies can crank out the yield.
ETF Options Strategies - Income Strategy ETF 12 mo Yield 12 mo Return Lg Cap Equity - Covered Call PBP 6.9% 11.5% Lg Cap Equity SPY 1.9% 16.4%
Bloomberg data as of 8/11/2014. Total return price.
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However, as we saw in the chart, the covered call strategies forego some upside; and that’s the case in this real world perfromance snapshot too. The key is to look at performance on a TOTAL RETURN basis, meaning yield plus price appreciation. On a total return basis, each of the 2 covered call strategies lag that of simply holding the underlying ETF over the past 12 months.
• Put Write • Same payoff profile as covered call • Hugely levered
ETF Options Strategies - Income
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Let’s quickly touch on another income-producing option strategy before we get to the hedging strategies. just talked about covered calls, which are identical to buy writes. Now will talk about put writes, also known as naked puts. The names here are similar, and this strategy has the same payoff profile as the covered call, as we’ll see on the next slide. The differerence is that it has no collateral required to construct the profile, hence the term naked. In pure form, this is a hugely levered play.
ETF Options Strategies - Income
Put Write
Bloomberg 8/11/2014
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This isn’t an overlay in other words; it’s a standalone short put. There’s no collateral baked into P&L, though you’ll likely need greater margin for this kind of strategy, and your risk is greater than the margin amount. It’s also possible that a naked strategy may conflict with investor policy constraints. Bottom line: you must be ready to by the underlying ETF. The draw here is earning outsized gains in the form of income relative to the capital required. The downside is being on the hook for losses far greater than your invested capital.
ETF Options Strategies - Income
Bloomberg 8/18/2014
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Leverage aside, put writes differ from covered calls in thet you’re selling puts, not calls. All else equal, puts are more expensive than calls, so it makes sense to sell them. In this example, we’re writing or selling calls on GLD, a volatile underlying, which also increase the value of the options. GLD spot is at 125.04; strike is 125, so the put is essentially at the money – that sounds risky since spot can quickly drop squarely into the money, which hurts you as the option seller. You can choose a strike that’s lower to reduce that likelihood. Note there’s no column here for underlying exposure. It’s just a short put.
ETF Options Strategies - Income
Strategy ETF 12 mo Yield US Equity - Put Write HVPW 9.3% US Equity VTI 1.8%
Bloomberg data as of 8/11/2014
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A quick performance check. Again, I’m using an all-in-one ETF as a proxy, HVPW, which employs a put-write strategy. Two quick caveats here. First, HVPW is fully collateralized with T-bills, so its not levered. Second, HVPW picks only 30 US stocks from the broad market– those with high volatility to earn big premiums. VTI, my proxy for tHVPW’s underlying market is quite crude since VTI is huge total market US fund. In other words, VTI is the universe for HVPW’s underlying. Still, I think the comaprison is useful. Over the past 12 months, HVPW has kicked off huge yield relative to the broad market Again, HVPW is not levered, so the yields are not goosed in that respect.
ETF Options Strategies - Income
Strategy ETF 12 mo Yield 12 mo Return US Equity - Put Write HVPW 9.3% 3.1% US Equity VTI 1.8% 16.0%
Bloomberg data as of 8/11/2014. Total return price.
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However, total returns for HVPW are weak; in factless than the yield implying price depreciation,. So the forgone upside here is substantial for this period.
• Why Options for Hedging? • Flexibility – Means and Outcomes • Tactical or Strategic • Popular & Tested Strategies • Costs Vary
ETF Options Strategies - Hedging
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Now, to the 2nd of 2 major objectives for today’s talk: hedging with ETF options. Why options for hedging? First is the great flexibility that these startegies offer. The flexibility is powered in part by the wide range of underlying ETFs – over 500. The ability to mix and match option types allows you to shape risk/return profiles. Like other hedging tools , such as futures or swaps, options are scalable. But they offer different return profiles than futures or swaps, and come with smaller capital requirements than inverse ETFs. The outcomes are flexible too: hedging tail risk , dampening volatility, or locking in a position within a range, and we’ll touch on each of these shortly. Second, Options well suited to both tactical and stratigic hedging, , though strategic implementation will require monitoring and rebalancing. Third, the hedging strategies themselves here are not new. What’s newer is the broad and growing use of ETFs and ETF options, which I believe makes the startegies more relevant than ever Fourth – investors can dial in the costs they’re willing to pay The costs vary – some are overt in the form of premiums paid; some are indirect in the form of foregone upside.. –we’ll hit those as we move through the strategies.
• Downside Hedging • Protective Put
• Max protection, higher strike • Left Tail Hedge, lower strike
ETF Options Strategies - Hedging
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Let’s focus on downside hedging first. The scope here isn’t merely reducing overall voaltility, its about protecting against drops in price in absolute terms, either partially or fully, while retaining upside. How nice is that. Long puts are a primary building block here Long puts can effectively protect you from downside. They can be quite expensive, but they’re scalable, and vary in cost with the level of protection they provide A protective put refers to your combined position –long puts plus long underlying assets. We’ll see a chart in a moment. When the strike price is very close to current price of the underlying ETF – you’re at max protection, which is very effective, and very expensive The delta of the put will approach -1 here for max protection, meaning an increase in the option value of $1 for every dollar decrease in the underlying ETF price. Delta is a dynamic number though, so to maintain this protection you’ll likely need to rebalance your position frequently if you’re really aiming for full downside protection. that means more time and trading expense. Still, the protection is real and the option cost may be cheaper than the hit you’d have taken without the protexction. Protective puts allow full downside protection without moving to cash, AND it retains upside, which cash certainly doesn’t do until you buy back in. Max protection isn’t the only play here however. You can by a much cheaper put that’s farther out of the money, aiming to hedge against a drop of a certain size – say 15% or 20%. This type of play would protect against black swans and market crashes, but not run-of-the-mill corrections. The beauty is that you have control over the costs and level of protection you seek, by selecting a strike price and time frame that meets your need.
ETF Options Strategies - Hedging
Protective Put
Bloomberg 8/11/2014
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The chart shows the downside protection. This is the sum of a long position in the ETF, which provides the upside at right, and the long put, which in combination with the ETF flattens the downside. This snapshot shows a strike of 190 on SPY while the ETF is trading at about 196. That’s very powerful protection against a drop of only 3% in price roughly. In round numbers, the cost of the options here is roughly $45 on $20,000 worth of SPY. That’s about ¼ of 1% or 25 basis points, excluding execution costs. This may not sound expensive, however it provides only 7 days of protection in this example, since the option expiry is only 7 days out. For longer protection, expect to pay more
• Put Spread • Reduce downside risk in a specific
range • Sell put to offset cost of long put
ETF Options Strategies - Hedging
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A more subtle and possibly more practical approach than a protective put is a put spread overlay. This strategy eliminates downside risk only in a certain range, meaning it doesn’t hedge out tail risk. It partially offsets the cost of the long put by selling a put, farther out of the money. The long put has a higher strike, so its has large, negative delta. It provides the protection The short put is farther out of money, but same underlying and same expiry. The strike price of each put sets range where protection occurs, and determines the net cost of the protection
ETF Options Strategies - Hedging
Put Spread, no
underlying
Bloomberg 8/11/2014
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Here are the 2 puts together, but without the underlying ETF The long put has a strike close to underlying; it gives the protection. Strike is 190 while SPY is at about $196 The short put is farther out of money (175 in this example) to offset cost.
ETF Options Strategies - Hedging
Put Spread, with
underlying
Bloomberg 8/11/2014
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Add in the underlying, which is long position in SPY shares. And voila, you get targeted, not full downside protection. Again, you retain upside as well. SPY’s at about 196, shown as a blue line – hard to see here, but to the right of the plateau of protection in green This example provides downside protection kicks in if SPY falls below 190,and extends all the way down to 175., about a 10% drop.. You’re still on the hook for losses below $175. These numbers are fully adjustable, depending on availability and liquidity of options at the strikes and dates you need. This strategy provides great protection agains a routine correction, but not a massive pullback.
ETF Options Strategies - Hedging
Bloomberg 8/14/2014
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Here’s a table showing the positions: Long put at 190, short put at 175, long SPY The net cost of the protection will vary depending on where the strike is set, and the time to expiration, among other things.
• Goal: Dampen Volatility • Covered Call
ETF Options Strategies - Hedging
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What if the goal is to dampen over all Volatility, rather than target the downside in particular It turns out that covered call strategies tend to reduce the overall volatility of the portfolio compared with the underlying ETF without the short call overlay. The cash flows from the strategy probably help.
ETF Options Strategies - Hedging
Strategy ETF Volatility Lg Cap Equity - Covered Call PBP 8.1% Lg Cap Equity SPY 10.4%
Gold - Covered Call GLDI 13.0% Gold GLD 16.2%
Calculated from Bloomberg data as of 8/11/2014. 12 month. Total return price. Annualized standard deviation of daily log returns.
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Here are the same ETFs we looked at earlier—all in-one ETFs that are proxies for the covererd call strategy. The volatility over the past year – measured by annualized standard deviation of daily returns—is markedly lower for the covered call strategies for both S&P 500 stocks and for gold. We see the same story routinely Here at ETF.com when we look at beta rather than standalone volatility. It’s lower for covered call strategies compared with the underlying ETF
ETF Options Strategies - Income
Covered Call
Bloomberg 8/11/2014
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“ Wait a minute” you may be thinking: “Don’t covered call strategies cap the upside but ride the downside? Are these strategies merely capturing the downside vol ,but giving up the “good” upside to get their lower over all volatility? Great question
ETF Options Strategies - Hedging
Strategy ETF Volatility Downside Volatility
Lg Cap Equity - Covered Call PBP 8.1% 9.8% Lg Cap Equity SPY 10.4% 11.5%
Calculated from Bloomberg data as of 8/11/2014. 12 month. Total return price. Annualized standard deviation of daily log returns. Target semideviation for returns < 0.
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However, when I measured the downside volatility for this exact same data set, it was again lower for the covered call strategies. The takeaway: If you overlay your existing long ETF with a short call to earn income, you’ll also likely lower your overall volatility. The real world numbers also show once again that the hockey stick charts we keep putting up on the screen are helpful to keep things straight, but they’re rough approximations of what’s going on.
• Goal: Lock in position, within a range • Collar
• Defines lower and upper bounds • Helpful prior to upcoming liquidity event • Option costs partially offset • Long put + short call + underlying
ETF Options Strategies - Hedging
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How about a different hedging goal, one that’s purely tactical. Say the investor has a significant expense on the horizon – a big wedding, a home down payment, or a tuition check—and plans to sell securities to pay for it. A collar can lock in the existing position, within a range, to allow for some price movement within a defined comfort zone but ensuring that the value meets the expense in worst case.
ETF Options Strategies - Hedging
Collar, no underlying
Bloomberg 8/14/2014
Presenter
Presentation Notes
It’s made from a long put & short call, in the same amount, with same expiry, on the same underlying ETF. Both out of the money. This chart shows the collar without the underling ETF. The Long put powers the upside on the left and has lower strike than ETF spot price (shown faintly in blue here). The short call drives the downside on the right and has a higher strike. The premium you receive from the short call helps to offset the cost of the long put.
ETF Options Strategies - Hedging
Collar, with underlying
Bloomberg 8/14/2014
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Presentation Notes
Here’s the collar plus the underlying ETF, which happens to be SPY. The net position combines a protective put and covered call Note this is a fundamentally different shape than the put spread, which had upside and downside with a plateau in the center, For the collar, the protection is to upside and downside, with room to run in the center, but bounded in a certain range , centered on SPY’s current price in blue. The thinking goes like this: I’ve had a nice run with SPY at 196. But I need to sell soon. I can tolerate a drop down to 190, but no less, and a little upside to 200 is nice to have. I’m willing to forego upside beyond 200 to help pay for the downside protection.
ETF Options Strategies - Hedging
Bloomberg 8/14/2014
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Presentation Notes
The cost of the collar is shown in the bottom row. Costs are shown as positives here, and gains from sales as negative. The long put at 190 costs $43; I get 14 for selling the call at 200, that’s a net cost of $29. This cost applies to about $20,000 worth of SPY, since options contracts are for 100 shares of underlying at 195.92. That works out to about 15 basis points, excluding execution costs. You can lower the cost by foregoing more upside or giving up more downside. 15 basis points sounds cheap, but bear in mind this covers only 14 days!. Annualized that’s closer to 4%. Still, for an investor or client planning to sell securities to meet a liquidity event, this approach may be well worth it .
• Inherently tactical • Listed vs OTC • European vs American • More liquid ETF; more liquid
option
ETF Options Strategies - Trading
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Presentation Notes
Want to wrap up here with a few thoughts on implementation before we take your questions. Working with options requires trading, sometimes frequent trading. Even strategic approaches may require regular rolling of the options and or monitoring and rebalancing. That means trading matters more than a typical buy and hold investment Listed options are those that trade on an exchnage like the Chicago Board Options Exchange. The contracts are standarized and counterparty risk is minimal. Options trade 8:30 -3 CENTRAL on the CBOE. In contrast, Over the counter options are bilateral agreements. For OTC, you bear Full counterparty risk but get greater flexibility European options can be exercised on expitation only. You can trade through to close out position at any time though. American can be exercised anytime Rule of thumb for ETF options – more liquid underlying ETF more liquid option
ETF Options Strategies - Trading
Bloomberg 8/15/2014
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Presentation Notes
Bid/ask spreads matter here as they do with underlying ETF – even for a liquid option on a liquid underlying. The spread descrives the differnce between what you pay to buy and what you receive to sell the same option. The quoted spread is a reference, not a guarantee. Some trades happen inside the spread, but some can move well outside when the trading book is narrow. We see the same thing in ETF trading. Use limit orders to help manage the spreads, but also know that limnit orders in less liquid markets may take a while to be filled, and may require resetting. Also be sure to consider the spread in basis points relative to the underlying exposure, not just pennies per option.. Scale the spread in cents by the share price of the underlying ETF rather than by the price of the option. In this snapshot, the trading cost per exposure to ETF share is about 13 bps, due in part to the large price, or handle of SPY, about $196 at the time. The same 25 cent spread on an ETF with a more typical $50 handle its closer to 50 basis points.
ETF Options Strategies - Trading
Bloomberg 8/15/2014
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Presentation Notes
In this snapshot, the market is less liquid for a December call on SPLV. A 35 cent spread relative to SPLV’s $34 share price is close to 100 basis points.
• Bid-ask spreads • Relative to ETF “handle” • Contract =100 shares of ETF
• Brokerage fees • Mind the ex-date for dividend-
paying ETFs
ETF Options Strategies - Trading
Presenter
Presentation Notes
So, bid-ask spreads are a big-part of execution costs. The ETF “handle” matters when considering trading costs measured in spreads, the handle being the ETF price in dollars, rounded. TO keep the math straight, recall that option prices are quoted for a single option, but the contract is for 100 options. Bear in mind that spreads are in addition to any brokerage fees. A more subtle point: for dividend paying ETFs, In- or at-the-money options will be sensitive in price to the underlting ETF’s ex-divividend date. All else equal the ETF price drops on the ex-date, which will push the price of a call down and a put up. If you’re short a call, the likelihood that you may be assigned notches up.
ETF Options Strategies - Trading
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SPY ETF VIX Index
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We’re almost done. A quick note on volatility The VIX index is used as measure of volatility. It’s based on options prices on the S&P 500, but it’s using the market’s option prices and backing out implied volatility from the Black Scholes equation. The point here is that Volatility is itself quite volatile, and recall that volatility is an input to option prices. The takeaway for trading options is that they’re going to be expensive in times of market duress. If you’re trying to use options to buy protection in times a volatility, it may be too late for it to be cost effective.
ETF Options Strategies - Trading
ETF.com, 8/15/2014
Options-Based ETFs BWV iPath CBOE S&P 500 BuyWrite ETN Equity FTLB First Trust Low Beta Income Equity GLDI Credit Suisse Gold Shares Covered Call ETN Commodities HFIN Horizons S&P Financial Select Sector Covered Call Equity HSPX Horizons S&P 500 Covered Call Equity HVPW ALPS U.S. Equity High Volatility Put Write Alternatives PBP PowerShares S&P 500 BuyWrite Equity QYLD Recon Capital NASDAQ 100 Covered Call Equity SLVO Credit Suisse Silver Shares Covered Call ETN Commodities VEGA AdvisorShares STAR Global Buy-Write Alternatives VIXH First Trust CBOE S&P 500 VIX Tail Hedge Equity
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Presentation Notes
2nd to Last slide before we take your questions: If you don’t want to trade options or run any of these startegies on your own, these off-the shelf ETF solutions might be for you. These options-based ETFs use the strategies we’ve talked about today. Upside: they do the work and charge a predictable all-in-one fee in the form of the expense ratio. Downside, Most come with the built in long exposure, so their not suitable as overlays. And they’re no where near as flexible as the DIY approach.. For more info on any of these ETF: ETF.com/ticker
• Income • Covered Call • Naked Put
• Hedging • Protective Put • Put Spread • Covered Call • Collar
ETF Options Strategies - Summary
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Presentation Notes
A quick summary For income, you can sell calls on new or exisitng long positions in ETFs to earn income. They kick off yield but forego some upside. Put writes also generate income, but without the long underlying. Naked means leverage upside and downside – More risk. You need to be prepared to buy the underlying, possibly at an unattractive price. For hedging, puts are the work horse. Max protection is very expensive , but retains full upside. Or you can protect only agains major downturns for less cost Put spreads are another way to mitigate hedging costs; they dial in downside protection in a targeted area. Covered calls dampen overall volatility. Collars confine the range of returns on the upside and downside; useul to lock in gains in a range. Time for some Q & A. Matt, what questions do we have coming in?
Matt Hougan President ETF.com
Graduate Seminar: ETF Options Strategies:
Hedging Risk, Building Income
Paul Britt, CFA Senior ETF Specialist ETF.com
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Presentation Notes
MATT Hello, and thank you for joining us for a Graduate Seminar - ETF Options Strategies: Hedging Risk, Building Income, the 7th session in our 10 part ETF university series. My Name is Matt Hougan of ETF.com. I’m joined by Paul Britt, senior ETF specialist. Before we get started, I wanted to give a special thank you to Deutsche Asset & Wealth Management and MSCI for sponsoring the webinar series and helping to make the ETF University possible. To answer a question we’re often asked, ETF.com is solely responsible for the content of this webinar, which underscores the sponsors’ generosity. Before we get started, a little housekeeping and to answer a few questions up front we always get. Yes, a replay of this webinar will be available at ETF.com in the coming days. Also, if you’re interested in CE credits, anyone attending the live webinar will receive an email with instructions on how to register your CE credits tomorrow. We’ve had strong interactive participation in this series, and we want to keep it going. If you have questions during this presentation, you can fire them in in the Q & A window on your screen, and we’ll address as many as we can at the end.
