Options on exchange-traded funds gain in popularity

Plentiful access to such trading, plus specialized ETFs, equals a recipe for growth

Nov 21, 2010 @ 12:01 am

By Jeff Benjamin

Some say that the only thing growing faster than the nearly $1 trillion exchange-traded-fund market is the use of options on those nearly 1,000 funds. That may be a slight exaggeration, but it does underscore a trend.

“In a volatile, but low, long-term-return environment, people look to options to generate income,” said Phil Guziec, an ETF analyst with Morningstar Inc.

The basic appeal of options is that they provide investors with tools to customize risk exposure and investment objectives in virtually any market environment.

A simple option collar, for example, might be used by a financial adviser to help nudge nervous investors toward greater equity exposure.

A collar strategy typically in-volves selling a call option for a “strike price” above the market price of an underlying security and simultaneously buying a put option at a below-market price.

Although the call option part of the collar will limit the upside gain, it helps finance the cost of the put option, which limits investment loss.

The collar is a conservative strategy and represents just one of the many ways puts and calls can be used to tailor or enhance an investment.

Beyond the collar strategy, there are almost limitless ways to boost performance or hedge an underlying position with options. One doesn't even have to own the underlying security in order to trade options on it.

And it has never been easier to trade options, thanks to liberalized market requirements and ample educational programs from groups such as the Options Industry Council, the neutral outreach arm of the nation's options exchanges.

There are nine options markets in the United States, up from five in 2000, the year some see as the start of the modern era for options trading.

STEADY GROWTH

Total trading volume of option contracts has been growing steadily for more than 10 years, to 3.6 billion last year, a fivefold increase over 726 million contracts in 2000.

Combine the relatively easy and plentiful access to options trading with an increasingly diverse and specialized ETF universe, and you have the perfect recipe for growth.

“A lot of ETFs have grown to the point where the options available on them are efficient and liquid,” said Scott Miller Jr., managing partner at Blue Bell Private Wealth Management LLC.

Mr. Miller's $300 million advisory firm started using options on ETFs about six years ago as a way to build in gains and add downside protection.

Despite the growing popularity, not all advisers are jumping in.

“We've looked at an option overlay on ETFs, but we felt the cost of managing the process was too high, relative to what you get in the form of insurance,” said Thomas Orecchio, a principal at Modera Wealth Management Inc., which manages $450 million.

Using options on ETFs, as op-posed to options on specific equity issues, introduces a wider margin for error, according to Jon Najarian, co-founder of OptionMonster Holdings Inc., which offers research, education and trading advice on options.

“Investors are using ETFs [as opposed to individual securities] because they're afraid of being in the right church but the wrong pew,” he said.

Mr. Najarian said that one of the most popular strategies he has seen lately is the “bull call spread,” which involves buying and selling call options with the same maturity but different strike prices on the same ETF — without owning the underlying ETF.

For example: A call was purchased Nov. 1 for the Pro-Shares Ultra S&P 500 (SSO), a leveraged ETF designed to generate twice the daily performance of the S&P 500, at $1.39 per contract.

The strike price on the contract was $43 and the maturity date was Nov. 19. At the time of the purchase, SSO was trading at $42, giving the option holder the right to buy the underlying ETF for $43 prior to Nov. 19, regardless of how high the price climbed.

This option strategy was balanced through the sale of a call on the same ETF for a $46 strike price — at a cost of just 29 cents a contract.

Without owning the underlying ETF, the investor risked only $1.10 a share, but has the potential upside of the difference between the two call option trades.

The strategies can get as complicated or as straightforward as an investor or adviser wants, but applying options to leveraged ETFs like SSO is part of the surge in interest, according to Mr. Najarian.

“I'm seeing an explosion of growth in options on leveraged ETFs because the option is defining exactly how much you're risking,” he said.

Although many of the options exchanges and educational platforms can lay out the basics of put and call option trading in less than an hour, Mr. Guziec said even knowledgeable traders can run into trouble.

“Options are powerful tools that you could compare to kitchen knives,” he said. “You can use a knife to prepare a wonderful meal, but if you're not careful, you can also cut off your finger.”

Ideally, options should be used to cushion volatility, especially for those new to the strategy, according to Sean Heron, who manages the Glenmede Secured Options Fund (GTSOX) for Glenmede Trust Co.

KNOW THE NUANCES

“Conceptually, it's very easy to trade options, but you can get yourself in trouble with the nuances,” he said.

“The trend we're seeing now is about learning to hedge, and not to speculate,” he added.

The risks and uncertainty are part of the driving force behind the MDE Group Inc.'s Planned Return Strategy, which is promoting an option collar on an S&P 500 ETF as a core investment strategy.

“I think people's greed factor has substantially subsided over the past few years,” said Mitchell Eichen, founder and chief executive of MDE Group, which has $1.3 billion under management.

For existing separate-account clients, Mr. Eichen said that the collar on the SPDR S&P 500 ETF (SPY) is being used to “replace all or most large-cap equity investments.”

But MDE is also in the process of rolling out the one-year-old strategy to the broader independent financial adviser marketplace as a turnkey options strategy that “allows investors to re-engage in the equity markets,” he said.

And the basic SPY collar is just the beginning, Mr. Eichen said.

“Right now our goal is to replace the S&P as a core investment,” he said. “If we start to generate volume and demand, we can create anything.”

The options industry is looking to financial intermediaries to continue to fuel the growth of options trading on ETFs, according to Eric Cott, director of financial adviser education at the Options Industry Council.

“It's the financial advisers who are recognizing the value of options,” he said. “When they're getting zero return on money markets, they need something to talk to their clients about.”

E-mail Jeff Benjamin at -jbenjamin@investmentnews.com.

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