ETF Options

By: EconomyWatch   Date: 4 August 2009

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Exchange traded funds (ETFs) are widely preferred by investors for their low cost structure, ease of trading and tax efficiency. Investors can benefit further from ETFs by buying and selling options on ETFs. Investors can use these ETF options to protect their portfolios or increase their profit potential.

ETF Options: Trading Strategies  

ETF options can be used to bet on the probable movement in the indexes underlying the funds. The indexes underlying the ETFs could range from a focused one, such as the PowerShares Global Wind Energy Portfolio, to a board-based one, like the iShares Russell 3000 Index Fund. Properly executed ETF options offer investors a chance to:

  • Realize substantial profits from smaller investments than that required for buying stocks

  • Minimize downside risk

Following are the strategies that can be used for trading in ETF options:

·        Buy a call option: A call option gives the right to buy the underlying ETF at a predefined price (called strike price) until the expiry date of the call. Traders profit from a long call option when the price of the ETF rises above the strike price and the purchase price of the call option.

·        Sell a call option: You can sell your call option if you expect the ETF price to decline. If your intuition is correct and the ETF price stays below the strike price, you will earn profits equivalent to the sale price of the option. However, if the price goes beyond the breakeven point of the sale price and the strike price, you would have to sell the ETF to the call owner and incur loses. 

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Buy a put option: A put option is the right to sell an ETF at a predefined price. If you expect the price of an ETF to fall, buying a put option is better than selling a call option. If the price declines before the expiry date, you can sell the put option at the strike rate and earn profits equivalent to the difference between the two prices.

·        Sell a put option: When you sell a put option, you surrender your right to sell the ETF at the strike price before the expiry date. You choose this strategy if you expect the ETF price to rise beyond the strike price. You earn profits equal to the sale price of the put option if the price moves according to your expectations. If the movement is unfavorable, you incur losses.


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