enhance etfs

1

Covered Calls Benefits & Tradeoffs

Joe Burgoyne Director, Options Industry Council

Enhance ETFs with Options Strategies January 26, 2016 Joe Burgoyne, OIC

www.OptionsEducation.org 748627.1.1

2 Options involve risks and are not suitable for everyone. Prior to buying or selling options, an investor must receive a copy of Characteristics and Risks of Standardized Options. Individuals should not enter into options transactions until they have read and understood the risk disclosure document, Characteristics and Risks of Standardized Options, available by visiting www.OptionsEducation.org. Copies may also be obtained by contacting your broker or The Options Industry Council at One North Wacker Drive, Chicago, IL 60606.

In order to simplify the computations, commissions, fees, margin interest and taxes have not been included in the examples used in these materials. These costs will impact the outcome of all stock and options transactions and must be considered prior to entering into any transactions. Investors should consult their tax advisor about any potential tax consequences.

Any strategies discussed, including examples using actual securities and price data, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities. Past performance is not a guarantee of future results.

Copyright 2015 The Options Industry Council. All rights reserved.

The Options Industry Council

3 Who We Are

About OIC The Options Industry Council (OIC) is an industry cooperative funded by OCC, the world’s largest equity derivatives clearing organization and sole central clearinghouse for U.S. listed options, and the U.S. options exchanges. OIC’s mission is to provide free and unbiased education to investors and financial advisors about the benefits and risks of exchange-traded equity options. Managed by OCC, OIC delivers its education through the Options Education Program, a structured platform offering live seminars, self-directed online courses, mobile tools, podcasts, webinars and live help. OIC’s resources can be accessed online at www.OptionsEducation.org or via mobile app for iOS. About OCC OCC is the world’s largest equity derivatives clearing organization and the foundation for secure markets. Founded in 1973, OCC operates under the jurisdiction of both the U.S. Securities and Exchange Commission (SEC) as a Registered Clearing Agency and the U.S. Commodity Futures Trading Commission (CFTC) as a Derivatives Clearing Organization. OCC now provides central counterparty (CCP) clearing and settlement services to 16 exchanges and trading platforms for options, financial futures, security futures and securities lending transactions. More information about OCC is available at www.theocc.com.

4 U.S. Listed Options Exchanges

5 Annual Options Volume, 1973-2015

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

Cle

ared

Con

trac

ts, B

illio

ns

Futures Non-Equity Equity

6 Options on ETF Annual Volume 2006-2014

0

200

400

600

800

1,000

1,200

1,400

1,600

1,800

2,000

2006 2007 2008 2009 2010 2011 2012 2013 2014

Mill

ions

of C

ontr

acts

7 Slide Presentation

• Options on ETFs

• Buy ETF Call

• Buy ETF Put

• Buy ETF Protective Put

• Covered ETF Call

• ETF Collar

• Conclusion

Options on ETFs

9 What are Options on ETFs?

• Options on ETFs are contracts that give • the holder the right and the writer an obligation • to buy or sell 100 underlying ETF shares • at the strike (exercise) price per share • at any time before the expiration date

• Considered equity options

• Available on a variety of ETFs • listed and traded on U.S. options exchanges

• LEAPS® may be available

10 ETF vs. Equity Options

Contract Terms

ETF

ETF Options

Stock

Equity Options

Underlying

Settlement

Unit of trade

Expiration

Last trade

Exercise style

Trading hours

Multiplier

Premium

Physical

100 Shares

third Friday of month (standard options)

Expiration Friday unless holiday

American

100

1 point = $100

May vary 8:30 am to 3:00 pm Central

11

• Factors • underlying ETF price • strike price • volatility of ETF shares • time until expiration • interest rate • dividends

• Implied volatility • assumption at which option currently priced • underlying ETF volatility expected by marketplace • generally lower for index than individual components

• Volatility and time decay affect only time value

ETF Pricing Factors

Same as Equity Options

12 Option Pricing Calculator

• Option pricing calculator accessible: • numerous Web sites • www.OptionsEducation.org

Example option pricing calculator For illustrative purposes only

13 ETF Options vs. Index Options

Physical settlement

American-style

Underlying may be bought/sold

Smaller strike increments

ETF Options

Cash settlement

Most are European-style

No underlying to buy/sell

Greater strike increments

Index Options

LEAPS contracts may be available for both

14

• Capitalize on market opinion with long options • potential for leveraged profits • predefined, limited loss

• Short-term plays on over- or under-performance • broad market, sectors or asset classes

• With appropriate ETF choice, adjust with one trade • diversification, asset allocation, correlation

• Hedge portfolio risk or with objective to boost returns

Ways to Use ETF Options

15 Optionable ETF Products

• Stocks

• Bonds

• Commodities

• Volatility

• International Stocks

• Currencies

• Fixed Income

• And more …

16 Commodity ETF’s

• ETF options can be used to invest in commodity markets without having to participate in futures markets

• Commodity ETFs have an advantage over CFTC regulated commodity options due to risk offset in that you can keep them in a securities account rather than a separate futures account

• Sector ETF’s can be used to help diversify a portfolio

and also provide volatility trading and risk management opportunities

17

Long Call Short Call Long Put Short Put Long Straddle Short Straddle

Long Strangle Short Strangle Long Call Spread

Long Put Spread

Short Call Spread

Short Put Spread

Ratio Call Spread

Ratio Put Spread

Long Split- Strike Synthetic

Call Volatility Spread

Put Volatility Spread

Collar

ETF options give you options!

Wide variety of strategies are available

Why ETF Options? Why Bother?

Buy ETF Call

19

• Investor bullish on an industry sector • unsure of specific stock to purchase • wants diversified long position • sector index tracked by ETF “XYZ”

• Decision: buy 1 XYZ call

• Possible motivations • speculation for leveraged upside profits • purchase underlying XYZ shares

Bullish Investor

20 Bullish Investor

• Choice of strike price depends on motivation

• In-the-money → more “conservative” • plan to exercise and buy ETF shares

• At or Out-of-the-money → more “speculative” • objective: sell call for profit

• More out-of-the-money the more speculative • set expectations accordingly

21 Buy Call Example

Not including commissions

• Opinion: bullish on XYZ over next two months

• XYZ currently at $75.00

• Action • buy 1 XYZ 74.00 call

at $2.90 • call in-the-money • total cost: $2.90 x 100 = $290.00

• Compare to XYZ purchase • buy 100 XYZ shares at $75.00 = $7,500.00 total

XYZ 74.00 call

XYZ 75.00 call

XYZ 76.00 call

Available 2-month calls

$2.90

$2.40

$1.90

22

+

Buy 1 XYZ 74.00 Call at $2.90

Break-even at Expiration: Strike Price + Premium Paid

$74.00 + $2.90 = $76.90

Maximum Loss: $2.90 Premium Paid

$290.00 Total

Profit Potential: Unlimited

–


0

5

5 BEP $76.90

70 75 80

Long XYZ at $75.00

23 Buy 1 XYZ 74.00 Call at $2.90

Long 74.00 Call Value at Expiration

$80.00

$78.00

$6.00

$4.00

($2.90)

($2.90)

$3.10

$1.10

Long 74.00 Call Initial Cost

Total Profit/(Loss)


XYZ Price at Expiration

$76.90 $2.90 ($2.90) 0

$74.00

$72.00

0

0

($2.90)

($2.90)

($2.90)

($2.90)

24

Long 74.00 Call Profit/(Loss)

Long Call % Profit/(Loss)

Long XYZ Profit(Loss) Per Share



Buy 1 XYZ 74.00 Call at $2.90 vs. Buy 100 XYZ at $75.00

$85.00

$80.00

$8.10

$3.10

279%

107%

$10.00

$5.00

13%

7%

Long XYZ % Profit/(Loss)

$75.00 ($1.90) (66%) 0 0

$70.00

$65.00

($2.90)

($2.90)

(100%)

(100%)

($5.00)

($10.00)

(7%)

(13%)

25 Buy 1 XYZ 74.00 Call at $2.90


• Exercise at expiration • buy 100 XYZ at $74.00 per share

• Net cost paid for XYZ shares • $74.00 strike + $2.90 premium paid = $76.90 per share • $7,690.00 total

• Risk before exercise • premium paid always at risk for all long ETF options

• Risk after exercise • downside on 100 long shares = $7,690.00

Buy ETF Put

27

• Investor bearish on broad market • uncomfortable with risk of any short stock positions • wants diversified short position with limited risk • broad market index tracked by ETF “XYZ”

• Decision: buy 1 XYZ put

• Motivation • speculation for leveraged downside profits

Bearish Investor

28 Bearish Investor

• Choice of strike price depends on motivation

• In-the-money → more “conservative” • has intrinsic value – less vulnerable to decay

• At or Out-of-the-money → more “speculative” • all time value – total cost vulnerable to decay

• More out-of-the-money, the more speculative • need greater move to downside for profit • set expectations accordingly

29

XYZ 74.00 put

XYZ 75.00 put

XYZ 76.00 put

Available 2-month puts

$2.00

$2.45

$3.00

Buy Put Example


• Opinion: bearish on XYZ over next two months • XYZ currently at $75.00

• Action • buy 1 XYZ 74.00 put

at $2.00 • put out-of-the-money

• Total cost: $2.00 x 100 = $200.00

30

+

Buy 1 XYZ 74.00 Put at $2.00

Break-even at Expiration: Strike Price – Premium Paid

$74.00 – $2.00 = $72.00

Maximum Loss: $2.00 Premium Paid

$200.00 Total

Profit Potential: Substantial

–


0

5

5 BEP $72.00

70 75 80

31

$76.00

$74.00

0

0

($2.00)

($2.00)

($2.00)

($2.00)

$72.00 $2.00 ($2.00) 0

$70.00

$68.00

$4.00

$6.00

($2.00)

($2.00)

$2.00

$4.00

Buy 1 XYZ 74.00 Put at $2.00


Long 74.00 Put Value at Expiration

Long 74.00 Put Initial Cost

Total Profit/(Loss)


32 Buy 1 XYZ 74.00 Put at $2.00


• Exercise at expiration • sell 100 XYZ at $74.00 per share

• Net received for XYZ shares • $74.00 strike – $2.00 premium paid = $72.00 per share • $7,200.00 total

• Risk before exercise • premium paid always at risk for all long ETF options

• Risk after exercise • short 100 XYZ shares – unlimited upside risk

Buy ETF Protective Put

34 Defensive Investor

• Investor long ETF “XYZ” • concerned about downside – protection wanted

• Decision: buy XYZ protective put • 1 put for each 100 XYZ shares owned

• Each protective put • grants right to sell 100 shares • at strike price until expiration • as long as put is owned

35 Defensive Investor

• Upside profit potential on XYZ shares • unlimited • less cost of put

• Downside loss on XYZ shares • limited • may be sold at strike price upon exercise

• Choice of strike price depends on protection needed

36 Protective Put Example


• Opinion: bullish on XYZ • defensive over next two months

• Long 100 XYZ at $76.00 • XYZ currently at $75.00

• Action • buy 1 XYZ 73.00 put

at $1.50 • put is out-of-the-money

• Total cost: $1.50 x 100 = $150.00

XYZ 72.00 put

XYZ 73.00 put

XYZ 74.00 put

Available 2-month puts

$1.20

$1.50

$1.95

37

+ Break-even at Expiration: ETF Price Paid + Put Premium Paid

$76.00 + $1.50 = $77.50

Maximum Loss: ETF Price Paid – Break-even for Put $76.00 – ($73.00 – $1.50) = $4.50

$450.00 total

Profit Potential: Unlimited

–


0

5

5 BEP $77.50

70 75 80

Buy 100 XYZ at $76.00 Buy 1 XYZ 73.00 Put at $1.50

Long XYZ at $76.00

38


Long 73.00 Put Value at Expiration

Long XYZ Profit/(Loss)

Total Profit/(Loss)



$85.00

$80.00

($1.50)

($1.50)

$9.00

$4.00

$7.50

$2.50

$77.50 ($1.50) $1.50 0

$75.00

$70.00

$65.00

($1.50)

$1.50

$6.50

($1.00)

($6.00)

($11.00)

($2.50)

($4.50)

($4.50)

39

• Exercise at expiration • sell 100 XYZ at $73.00 per share

• Net received for XYZ shares • $73.00 strike – $1.50 premium paid = $71.50 per share • $7,150.00 total

• Risk before exercise • limited



Covered ETF Call

41 Investor Seeking Income

• Investor • neutral to moderately bullish on ETF “XYZ” • expects small price range over next few months

• Decision: write covered call • buy 100 XYZ shares • write 1 XYZ call

42 Investor Seeking Income

• Primary Motivation – increase returns • call premium received and kept • generates additional income (over any dividends) • trade-off is upside on shares limited by short call

• Call premium’s limited downside benefit • lowers XYZ shares’ break-even point • reduces cost basis • only by premium amount received

43 Covered ETF Calls

• Call writer’s obligation • sell XYZ shares if assigned at any time

before expiration

• Long XYZ shares “collateralize” short call obligation • if assigned shares sold already owned

• Risk is in the long XYZ shares

Long ETF Covered ETF Call


• Write in-the-money call • defensive and more conservative • more premium received → more downside protection • less upside profit potential

• Write out-of-the-money call • aggressive and less conservative • less premium received → less downside protection • more upside profit potential


• Strike price selection • assess your tolerance for risk • balance upside profit potential vs. limited protection • pick strike accordingly

• Generally considered “conservative” strategy • reduces (not limits) downside risk

• Outperforms long XYZ shares • if price declines, unchanged or rises slightly


• Maximum profit potential if assigned • limited • strike price – share price paid + call premium received

• Break-even point • share price paid – call premium received

• Downside loss potential substantial • risk is with XYZ shares • entire share cost less call premium received at risk

47

• Opinion: neutral to moderately bullish on XYZ

• XYZ currently at $75.00

• Expect XYZ to trade between $73.00 and $77.00 for next 90 days

• Action • buy 100 XYZ at $75.00 • sell 1 XYZ 77.00 call at $2.10

• A $0.50 dividend is expected before expiration

XYZ 73.00 call

XYZ 74.00 call

XYZ 75.00 call

XYZ 76.00 call

XYZ 77.00 call

Available 3-month calls

$3.95

$3.40

$2.90

$2.45

$2.10

Covered ETF Call Example


48

+ Break-even at Expiration: ETF Price – Premium Received

$75.00 – $2.10 = $72.90

Maximum Loss: Substantial

Maximum Profit if Assigned: (Strike Price – ETF Price Paid) +

Call Premium Received ($77.00 – $75.00) + $2.10 = $4.10

$410.00 total –


0

5

5

73 77 80


Profit and Loss at Expiration

BEP $72.90

49

$85.00

$80.00

$10.00

$5.00

($5.90)

($0.90)

$75.00 0 $2.10 $2.10

$70.00

$65.00

($5.00)

($10.00)

$2.10

$2.10

$4.10

$4.10

($2.90)

($7.90)


Long XYZ Profit/(Loss)

Short 77.00 Call Profit/(Loss)

Net Profit/(Loss)



Profit and Loss at Expiration

Buy 100 shares XYZ at $75.00 Sell 1 XYZ 77.00 call at $2.10

50 Early Assignment for Dividend

• Early assignment possible before dividend • on or just before ex-dividend date

• You might expect early assignment when • expiration is relatively near • dividend greater than call’s time value

• XYZ will pay $0.50 dividend • ex-dividend date four days before expiration • day before ex-date XYZ is at $78.50 • 77.00 call is at $1.60 • time value is $0.10 → expect assignment

Return Calculations

52

$2.10

$0.50

$2.60

$75.00

3.5%

4.1

14.35%

Static Return Worksheet: Stock Unchanged

Call price less commissions

Plus dividends +

Equals income =

Divided by (ETF price plus commissions) ÷

Equals % income =

Times 365/90 (days to expiration) x

Equals annualized static return =

53 If-Called Return Worksheet: Stock though the Strike

Call price less commissions

Plus dividends +

Plus profit from ETF sale ($77.00 – $75.00) +

Equals income =

Divided by (ETF price plus commissions) ÷

Equals % income +

Times 365/90 (days to expiration) x

Equals annualized static return =

$2.10

$0.50

$2.00

$4.60

$75.00

6.1%

4.1

25%

54 Covered Call

Nervous About Downside?

• In the previous example an investor wrote a covered ETF call

• Position • long 100 XYZ shares at $75.00 • short 1 XYZ 77.00 call at $2.10

• Time passes • XYZ increases in price a bit • investor has downside worries - doesn’t

want to sell shares • buy protective put → convert to a collar

ETF Collar

56

• Collar • long 100 underlying ETF shares • long 1 put • short 1 call

• Ratio always 100 shares : 1 call : 1 put

• Call and put generally same expiration month

• Call strike price higher than put strike price

What is an ETF Collar?

57

• A collar can be considered two strategies in one • the 100 ETF shares play a part in both

• On the downside a protective put • out-of-the-money put is purchased • right to sell shares at strike price until expiration

• On the upside a covered call • out-of-the-money call is sold • upside profit potential limited by short call

Collar: Two Strategies in One

58

• ETF buyer with unrealized gains wants • downside protection – long put • some upside participation – limited by short call

• Key benefits • put cost fully or partially paid by call premium received • objectives met whether share price up or down • receive any dividend if not assigned on short call

Why Use a Collar?

59

• Downside protection needed? • select appropriate put strike price • consider time frame

• Upside participation on ETF? • select appropriate call strike price • be happy with share sale price if assigned

• Balance two factors: • put premium paid and protection provided – risk • call premium received and upside potential – reward

Before You Use a Collar

60


Net Debit

Put cost more than call premium received

What Does All This Cost?

Buy put – $3.00 Sell call + $2.00

Net debit – $1.00

Net Credit

Call premium received more than cost of put

Sell call + $4.00 Buy put – $1.00

Net credit + $3.00

“Zero Cost”

Call premium received same as put premium paid

Sell call + $4.00 Buy put – $4.00

Zero Cost $0

61 ETF Collar Example

• Covered call • buy 100 XYZ shares at $76.50 • sell 1 XYZ 77.00 call at $2.10

• Convert to collar • buy 1 XYZ 75.00 put at $1.65

• Position long 100 XYZ shares currently at $76.50 sell 1 XYZ 77.00 call + $2.10 buy 1 XYZ 75.00 put – $1.65

Net credit = + $0.45


Conclusion

63 Conclusion

• Among the benefits ETF shares offer • diversification and allocation with a single transaction • trade like stock on an exchange • lower management costs and certain tax advantages

vs. mutual funds

• ETF benefits available to option investors

• ETF options are considered equity options • same pricing factors • similar contract terms • American-style and physical delivery – unlike

index options

64 Conclusion

• ETF options offer flexibility of equity options • wide range of strategies available

• Why use ETF options? • bullish or bearish speculation • buy or sell underlying ETF shares • generating additional income • managing portfolio risk

65 The Options Education Program

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66 For More Information

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