Using Options to Hedge an ETF Portfolio

By Carl Delfeld of Chartwell ETF 

Many ETF investors are unaware that roughly 40% of ETFs have options that can be used to hedge positions, take advantage of leverage or straddle markets to bet on volatility. For some ETFs, option maturities go out as far at January 2011 and, in November, the January 2012 options will hit the market.

The easiest way to find out if options are available for a specific ETF is to go to Yahoo Finance and put in the ticker. On the left side will be a menu. Just click on the “options” link and, if options are available, they will come up for review.

Before jumping into options trading, you should consult with your financial advisor and do some research as to the basics. You can keep it simple like checkers, or get a bit more sophisticated like chess.  

A good place to start may be brushing up with options basics from Investopedia, including definitions of some key terms like call options and put options.

Hedging a long ETF position

One of the simplest uses of options is to use it to hedge a long ETF position. For example, I have in the past discussed in Chartwell ETF how to use a put as “China insurance”.

Suppose that you think China (FXI) will go up but you are uncomfortable with the downside risk that goes along with investing in China. You go purchase FXI and at the same time purchase an FXI put option (right to sell) with an expiration date in January 2011. The cost of this is the “premium” which will depend on what “strike price” you choose. If the FXI goes up more than the price of this premium, you will make a profit. If FXI goes the wrong way, you loss will be somewhat offset by the put option in place. I refer to this as a portfolio “shock absorber”.

Covered Calls

This well known conservative strategy can increase your returns. But perhaps the simplest way to execute this strategy is using ETFs that do it for you. There are two possibilities. Two of the best-known buy/write ETFs are IQ Investor Advisors’ S&P 500 Covered Call Fund (BEP) which is a closed-ended fund going back to March 2005 and the PowerShares’ S&P 500 BuyWrite Portfolio (PBP) that was launched in late 2007. Both seek to track the CBOE BuyWrite Monthly (BXM), an index based on a covered call strategy for the S&P 500.

The ETF Straddle
Sometimes an investor faces a situation of great uncertainty and volatility. Banks in early 2009 would be a great example of this environment. No one new if they would go up 50% or down 50% as a sector. An investor could take advantage of this dilemma buy buying both a put and call option at the same or different strike prices. If the underlying banking sector ETF goes up or down by more than the combined premiums, it will turn into a profitable trade.

Naked Call or Put
There are some strategists that believe buying call (right to buy) options is always preferable to purchasing the stock or ETF on a cash basis.
Let’s look at one example and see why. If you wish to invest in 100 shares of Brazil (EWZ) at a price of $50 your total cash outlay and exposure is $5,000 excluding commissions. However, the price of a January 2010 call option on EWZ at the $50 strike price is just $6 meaning you can have the option of buying 100 shares of EWZ for a premium of $600. You could lose all of the $600 if EWZ goes and stays below $50 through January 2010 but that is all you can lose.
Your $5,000 exposure to EWZ in the cash scenario is totally exposed and theoretically could go to zero.

Deep Naked Call or Put 
Sometimes if you have a deep conviction or gut feeling that an ETF is going in one direction because it is very much undervalued or overpriced, a deep out-of-the-money call or put may work. This is definitely speculation since if the ETF or stock moves the opposite way or even if it moves in the right direction but not forcefully, you will probably lose all your premium. I call this a “swing for the fence” strategy with the commensurate risk of striking out. At least all your friends won’t be watching.

An example of this situation was earlier this year when many international markets had fallen 50%-70% from they 2008 highs and looked incredibly cheap. There was a high likelihood that they would come back but when was basically anyone’s guess. I bought some January 2011 deep out-of-the-money calls on a few country-specific ETFs and posted some incredible returns due to the leverage inherent in such a strategy. I have also done this with (TBT) that moves inversely to the long Treasury bond on the assumption that long-term rates will have to increase in order to attract the financing that goes with our explosion in federal spending.

ETF options poise special risks but the leveraged rewards and the ability to use them to manage risk may make them an effective tool for some.