Spotlight on ETF options

How to use them to trade or protect positions.

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There are myriad reasons to like ETFs. Similar to mutual funds, they allow you to access many parts of the market—stocks, bonds, sectors, industries, currencies, and more. Many ETFs are relatively low cost, and can be tax efficient. You can use them to build a diversified portfolio or implement a more targeted strategy. Plus, unlike mutual funds, ETFs trade intraday like stocks—potentially making them attractive to short-term, active traders, in addition to longer-term investors.

No wonder money has poured into the exchange-traded product (ETP) market, which is composed predominantly of ETFs. U.S. ETP assets hit a record $2.1 trillion last year, triple that of 2009.1

But did you know that you can also trade options on 275 ETFs (representing about 20% of all those listed on U.S. exchanges) for a fraction of the cost of the underlying ETF? Options contract volume on U.S.-listed ETF options hit a record 1.7 billion contracts in 2011, up more than fivefold from 2006. After a pullback in 2012, those contract volumes have begun rising again (see graphic).

Whether you are looking to establish a position on a segment of the market, hedge an investment, or just implement an investing idea, ETF options can be a useful tool for experienced options investors.

How they work

If you trade stock options, you should have little trouble utilizing ETF options. Similar to plain vanilla stock options, ETF options have standardized contract terms. They are American style (offering the possibility of early exercise and assignment) and are physically settled upon exercise by the delivery of the underlying ETF shares, unless the option position has not been closed by an offsetting trade.

Of course, there are unique characteristics and risks associated with ETFs that can affect ETF options—including market risk and exposure to exotic parts of the market that involve increased complexity, among others. However, in general, ETF options offer the same investment capabilities as stock options.

Implementing ETF options strategies

Suppose you believe U.S. large-cap stocks were set to rally, but you didn’t want to invest a lot of your money in the market just yet. You could buy a SPDR S&P 500 ETF (SPY) call, for example, which gives you the right, but not the obligation, to buy SPY at a predetermined price for a set time. SPY was the first and largest ETF, and it seeks to track the 500 largest U.S.stocks. The primary reason for buying calls, as opposed to simply buying a stock or ETF, is that options enable you to control the same amount of shares with less money.

Alternatively, what if you are worried about a short-term U.S. stock market correction, but don’t want to sell your U.S. holdings? You might consider a short‐term strategy where you would buy a put on the SPY. An SPY put would give you the right, but not the obligation, to sell the SPY at a predetermined price over a specific time period. The put would gain in value if the SPY declined in price after you purchased it. You would purchase put options to capitalize on a bearish outlook, and to have a known, limited-risk—in contrast to a short stock position.

Or, let’s say you have analyzed the business cycle and are bullish on the telecom sector, but are unsure which stocks to buy. You could consider purchasing call options on a telecom sector ETF. There are several telecom sector ETFs, so you could consider narrowing your available choices using Fidelity’s ETF screener to generate a list of highly liquid telecom ETFs that meet your investing criteria and are optionable. Then, you can go to the options chain for that ETF (available in Fidelity.com or Active Trader Pro®–login required) to see what options are available. On Fidelity.com, you can find the options chain by clicking on the Research tab and selecting Options. On this options research page, select Quotes and Tools and then enter an ETF symbol. If the ETF has options, the options chain will appear.

Of course, just as you should thoroughly analyze the broad market or a telecom stock and its associated options, you would need to do your due diligence on the SPY or telecom ETF. Consider the ETF’s liquidity, how well it tracks its benchmark (e.g., tracking error), the costs, tax implications, and any other factor that may influence your strategy.

Finding ETF options opportunities

Thanks to the numerous, and growing, ETFs that exist, options investors may be able to take advantage of market outlooks in ways that were previously difficult to do using options. There are ETF options covering themes like market cap, sectors, global markets, commodities, interest rates, and volatility, affording investors a multitude of ways to utilize ETF options.

There are several ways you can find ETFs that offer options. As previously noted, you can go to the options chain to search for a specific ETF option. If you would like to explore options trading ideas, you can go to Fidelity.com, click the Research tab, and select Options. On the options research page, select Trading Ideas. Here, you can use tools such as Strategy Ideas and the Report Finder to search for option-specific strategies based on an ETF or a strategy. The list of trading strategies and ETF ideas is generated by LiveVol and S&P Capital IQ, independent options research providers.

Once you are on the options pages, there is a wealth of information and strategies to explore. You can also see which ETFs are most active each day by visiting the Options Industry Council’s (OIC) website, then click on the ETF tab. The most active ETFs typically offer relatively strong liquidity, compared with infrequently traded ETF options, which can help reduce total costs. Also, ETFs or stocks with stronger liquidity may offer more options contracts, which may allow you to find the best contract for your strategy.

For instance, on May 3, 2016: the most active ETF options, according to the OIC website, were:

  • SPDR S&P 500 (SPY)
  • iShares Russell 2000 (IWM)
  • Powershares QQQ ETF (QQQ)
  • iShares MSCI Emerging Markets ETF (EEM)
  • Industrial Select Sector (XLI)

Learn more

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1. Source: Ernst & Young, as of January 15, 2016.
2. Source: Options Industry Council, as of March 30, 2016.
Options trading entails significant risk and is not appropriate for all investors. Certain complex options strategies carry additional risk. Before trading options, please read Characteristics and Risks of Standardized Options, and call 800-544-5115 to be approved for options trading. Supporting documentation for any claims, if applicable, will be furnished upon request. ETFs are subject to market fluctuation and the risks of their underlying investments. ETFs are subject to management fees and other expenses. Unlike mutual funds, ETF shares are bought and sold at market price, which may be higher or lower than their NAV, and are not individually redeemed from the fund.
Before investing in any mutual fund or exchange-traded fund, you should consider its investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus, offering circular, or, if available, a summary prospectus containing this information. Read it carefully.

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