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Op-Ed: An Options-Based ETF Strategy Can Generate Income, Manage Risk

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  • Virtually non-existent bond yields are prompting interest in junk bonds, exposing investors to more risk. Meanwhile, stock investors worry about the impact of market volatility on portfolios.
  • The solution to both problems for some may lie in options strategies, long used by professionals and sophisticated investors.
  • Individual investors can benefit from options ETFs if they start small after getting educated on benefits versus costs.

In this period of virtually non-existent bond yields, the search for income is prompting increased interest in junk bonds, exposing investors to more risk. Meanwhile, stock investors are concerned about the impact of market volatility on their portfolios.

For some investors, the solution to both problems may lie in options strategies long used by professionals and sophisticated individuals.

The complexities of executing options — contracts for the prospective sale or purchase of specific stocks during a set time period — makes them inaccessible for most individual investors. But over the past few years, a variety of options-based exchange-traded funds have come on the market. This has afforded individuals easy access to various options strategies to produce income, hedge risk or both.

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Option-based ETFs are geared to either hedging (protecting investors from losses in a down market), or providing supplemental income to another investment strategy.

For hedging, they often use put options, which give shareholders the right to sell the underlying stocks at a preset price if the actual price falls below that threshold. For supplemental income, they often use puts or calls, option contracts giving the owner the right, but not the obligation, to buy a specified amount of an underlying security at a preset  price within a specified time frame.

The introduction of about 120 such ETFs in the past few years has taken this category from an obscure corner of the market to a highly visible place. Adoption has been rapid amid a search for income that has intensified as real bond yields (net income after inflation) have dipped below zero.

Options-based ETFs are gaining traction as investors struggle to reconcile high stock prices and historically low bond yields. To that point, inflows into options ETFs so far this year are estimated at more than $8 billion. ETFs designed for hedging alone posted inflows totaling about $5 billion for the 12 months ending Aug. 31 — an indication that many shareholders are using these products for risk protection.

For many individual investors, the rationale of these products may seem counterintuitive because they see volatility as being synonymous with risk. Yet well-conceived, well-executed options strategies can actually reduce risk.

True risk is the chance of permanent loss of capital. Despite their general reputation for safety, this is possible with bonds. Though stocks are called "risk assets" because of their volatility, this fluctuation in value creates opportunity for both income and risk reduction.

Some options ETFs have posted double-digit share-price gains so far this year, with annual dividend yields well upwards of 5% in many cases. So these investments can provide more income than high-yield (junk) bonds, even if their share prices languish.

Yet easy access to options strategies can be a double-edged sword for individual investors because failing to understand their dynamics may mean underestimating various risks and failing to select products appropriate for their situations. Before investing, it's best to take some time to understand the risk-reward dynamics involved.

As with most investments, evaluating these products involves weighing tradeoffs. In the usual risk-reward teeter-totter, when income potential goes up, risk protection tends to go down and vice-versa.

The $4.2 billion Global X Nasdaq 100 Covered Call ETF (QYLD) gets income from selling calls (which give owners the right to buy a particular stock for a set price during a set time frame) on stocks in its namesake index. If the index rises above a set threshold, the fund has to sell shares or cough up cash to cover these calls.

Although the index was up about 20% this year as of early September, the fund was only up about 9%. Nationwide Risk-Managed Income ETF (NUSI) also uses options on stocks in the Nasdaq 100.

Global X offers two products similar to QYLD, based on other indexes: the S&P 500 (XYLD) and the Russell 2000 (RYLD). The firm announced the launch of six new options-based ETFs in late August.

Some options ETFs seek to put a floor on losses by buying puts. As this can be expensive, various buffer ETFs ("buffer" is sometimes the name of the fund) offset this cost by selling calls.

These buffer products often guarantee a floor on losses for set periods, an attractive feature for the risk-averse investors. Yet these investors should be sure to understand the limits of this protection and the time period involved.

Further, some of these buffer products carry a risk of long-term underperformance stemming from the costs of hedging. These costs are often funded by selling calls, and the opportunity cost involved can be a cap on the upside; there's no free lunch.

Simplify US Equity PLUS Downside Convexity ETF (SPD), currently at $283 million, doesn't write call options, so the upside isn't capped. But there's no floor on losses, either. (Teeter, totter.) To reduce risk, put options are overlain on shares of an S&P 500 Index ETF.

Other products seek income from dividends and options traded on stocks that pay regular dividends.

For example, the $647 million Amplify CWP Enhanced Dividend Income ETF (DIVO), which holds a portfolio of blue chip stocks and writes covered calls on those that managers don't expect to do well during selected periods. The more accurately these managers anticipate the range of these stocks' price movements, the more income the fund can generate.

Individual investors can benefit from options ETFs if they start small after getting educated on their benefits versus costs.

These funds tend to have different structures and different goals, so comparing them can be like comparing apples to oranges. Choosing between them isn't like choosing between index funds of large-cap value stocks, for example, where each is fairly similar to the other.

And, as always, investors should make selections consistent with their individual risk tolerance and investing goals. 

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