Defensive Portfolio Strategies Using ETF Options

Options can be used in several ways in an investment portfolio.  Let’s cover very high level Options basics before getting into some of their uses.  If you want to learn more about Options, see the Options Education links on the Resources page.

What Is An Option?

An option is a contract in which the buyer of the contract has the right to buy (or sell) an ETF and the seller has an obligation to sell (or buy) that same ETF as specified in the contract.  Each option contract represents 100 shares of an ETF, not just 1 share.

There are 2 types of Options, a call option and a put option.

Call Option

A call option is an option to buy an ETF at a specific price, on or before a certain date (known as Option expiry date).  The reason to buy a call option is if you think the price of the ETF the option is based on (the underlying) is going to go up.

Example

Assume:

  •  XIU (iShares S&P/TSX 60 Index ETF) is trading today at $17.75 per share.
  • An $18.00 Call Option contract expiring 3 months from today is trading at $0.50 per contract.  The $18.00 specified on the contract is known as ‘strike price’.
  • You purchase this contract for $0.50.  Since each contract represents 100 shares, your cost is $0.50 x 100 = $50.

Situation 1:  XIU Trading Above $18.00 Strike Price At Option Expiry Date

Now, 3 months go by and just before the option contract expires, XIU is now trading at $19.00.  You own an option to buy XIU at $18.00, which now has market value of $19.00.  In this case, you will exercise your option and collect your profit.

Profit =  (Market value of ETF – Strike Price in contract – Price paid to purchase the contract) x 100
= ($19.00 – $18.00$0.50) x 100 = $50

Note that as long as the value of the underlying ETF, in this case, XIU, is trading above the strike price, the owner of the call option will exercise the option to capture any gain.

.Situation 2:  XIU Trading Below Strike Price ($18.00) At Expiry Of The Option

In this scenario, suppose XIU is now trading at $17.00.  You own an option to buy XIU at $18.00.  In this case, you wouldn’t want to exercise your option to buy XIU at $18.00 since you can simply buy the XIU shares for $17.00.  You end up losing the amount you paid to buy the contract in the first place, which is $50.

Put Option

A put option is an option to sell an ETF at a specific price, on or before a certain date (known as Option expiry date).  The reason to buy a put option is if you think the price of the ETF the option is based on is going to go down.

This works the same way as a call option, except in the opposite direction.  The buyer of the put option will profit if prices go down.

Applications of ETF Options

We can buy options to hedge (protect) our portfolio, or we can sell options to generate additional income within our investment portfolio.

Hedging

We can hedge our portfolio from a market decline by purchasing Put options.  As mentioned earlier, Put options on an ETF will increase in value if the price of the underlying ETF declines in value.

Hedging can be thought of as buying an insurance policy for your investment.  The cost of purchasing the put option for protection is like paying the premium for your insurance.

Example

Assume:

  • You own 1000 shares of XIU in your portfolio which is trading at $18.00 per share.
  • You decide you want to protect 20% of that position over the next 3 months.

To protect 20% of the position means we want to protect 200 shares (1000 shares x 20%) from a decline in value.  Since each put option contract represents 100 shares, we need to purchase 2 option contracts.

So, to hedge 200 shares, we can purchase 2 put options with a strike price of $18.00 which expires in 3 months.  If XIU starts trading below $18.00, the put options will start gaining in value, offsetting some the loss of value on the XIU shares.

If XIU trades at $18.00 or higher, the put option will become worthless over time.

Generating Income

One of the easier (not necessarily easy) option strategies other than simply buying/selling a call or a put is what is known as covered call writing.  Covered call writing involves owning (or buying shares) of an ETF and then selling a call option .

In order to implement a traditional covered call writing strategy, you must own shares of the stock or ETF and then sell a call option.  By selling the option, you collect some income (the option premium or the cost of the option) right away.

In a covered call strategy, your upside profit potential is limited since you sold a call option.

Example:

  • You own 100 shares of XIU trading at $17.75
  • You sell 1 call option (representing 100 shares) with a strike price of $18.00, which expires in 3 months
  • You were able to sell the call option for $0.50 (which gives you an income of $0.50 x 100 shares = $50)

Let’s examine what happens under 3 specific scenarios:

Case 1:  Price of XIU doesn’t change for 3 months

If XIU ends up staying at $17.75, the option you sold expires worthless and you get to keep the $0.50 you collected when you sold the option.

Case2:  Price of XIU rises to $18.25 over the next 3 months

If XIU is at $18.25, you get to profit from the rise in price of your shares from $17.75 to $18.00.  Any gain above $18.00 will be offset by a loss on the call option you sold.  You still get to keep the $0.50 premium you collected for selling the option.  In this scenario, you make a total of $0.75 per share ($0.50 from selling the option + $0.25 from rise in price of XIU).  If you only had the shares and didn’t sell the option, you would have gained $0.50 from the rise in shares from $17.75 to $18.25

Case3:  Price of XIU drops to $17.00 over the next 3 months

If XIU drops to $17.00, you lose $0.75 per share on your ETF.  However, you still get to keep the option premium of $0.50 from the sold call option which expires worthless.  Your total loss is reduced to $0.25 per share instead of $0.75.

Covered call writing strategies work better when the market prices are not changing rapidly.  The covered call strategies will underperform the market in markets that rise rapidly.  In theory, this strategy should also makes you lose less when markets go down rapidly.

Final Words

You don’t need to implement these yourselves as there are ETFs available that implement the ideas discussed above in some form.  Horizons offers what they call their ‘Black Swan’ ETFs where they hedge the position value from significant market declines.

As for the covered call ETFS, to date, Horizons, BMO, and First Asset offer a variety of ETFs that implement this strategy.  They each follow a different methodology so be sure to read the details before choosing one.

Although the strategies discussed above help protect your investments when prices go down, all options involve risk.  The ideas in this post are for informational purposes only and should not be construed as investment advice.

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