In recent years, exchange-traded funds (ETFs) have become increasingly popular among UK investors looking for a low-cost and diversified way to invest in the stock market. At the same time, listed options have also gained traction as a flexible tool for managing risk and generating income. But what is the relationship between listed options and ETFs, and how can investors use both to achieve their investment goals?
Listed options are derivative securities allowing the holders the right to buy or sell the asset at a predetermined price (the strike price) on or before a specified date (the expiration date). Listed options are traded on organised exchanges, such as the Chicago Board Options Exchange (CBOE) and the International Securities Exchange (ISE). They are standardised regarding contract size, expiration date, and strike price.
ETFs are investment funds that trade on stock exchanges like individual stocks. ETFs can track various assets, such as stocks, bonds, commodities, or currencies, and provide investors with diversified exposure to a particular market or sector. ETFs can offer lower fees and higher liquidity than traditional mutual funds, making them a popular choice for both retail and institutional investors.
One of the key benefits of ETFs is their diversification potential. By investing in a single ETF, investors can gain exposure to a whole market or sector, reducing their exposure to individual stock risks. However, even with diversification, ETFs can still be subject to market volatility, impacting their value. This is where the listed options come in.
Listed options can be used to hedge against potential losses in ETFs. For example, if an investor holds a large position in an ETF that tracks the FTSE 100 index, they can buy put options on the same index to protect against a potential market downturn. Put options give the holder the right to sell the underlying asset at the strike price, allowing investors to limit their losses if the value of the ETF falls below a certain level.
Listed options can also be used to generate income from ETFs. For example, if an investor holds a long position in an ETF, they can sell call options on the same ETF to generate income. Call options give the holder the right to buy the underlying asset at the strike price, allowing investors to earn a premium in exchange for potentially giving up some of the upside potentials of the ETF.
In addition to hedging and income generation, listed options can enhance ETF returns. For example, an investor can use call options to leverage their exposure to a particular ETF, potentially increasing their returns if it performs well.
An investor can use call options to leverage their exposure to a particular ETF by buying call options on the ETF. A call option gives the holder the right, but not the obligation, to buy the underlying asset at a predetermined price (the strike price) on or before a specified date (the expiration date). By buying call options on an ETF, investors can increase their returns if the ETF performs well.
For example, suppose an investor believes that the iShares MSCI United Kingdom ETF (EWU) will perform well over the next few months. They could buy 100 shares of EWU at its current market price of £28.50 per share, which would cost them £2,850. Alternatively, they could buy 10 call options on EWU with a strike price of £30 and an expiration date three months from now. Each call option represents 100 shares of EWU, so buying 10 call options would give the investor exposure to 1,000 shares of EWU.
Assuming that the premium for each call option is £1, the investor would need to pay a total of £1,000 (£1 premium x 10 options x 100 shares per option) for the call options. If EWU’s price increases to £32 by the expiration date, the investor could exercise their call options and buy 1,000 shares of EWU at the strike price of £30 per share. They could then sell the shares at the current market price of £32, generating a profit of £2 per share or £2,000 in total. Deducting the initial cost of the call options (£1,000), the investor would have a net profit of £1,000, representing a return of 100% on their investment.
It’s important to note that leveraging an investment through call options amplifies potential losses if the ETF performs poorly. In the above example, if EWU’s price falls below the strike price of £30, the call options would expire worthless, and the investor would lose the entire £1,000 premium they paid for the options. Therefore, investors should carefully consider the risks involved in using call options to leverage their exposure to ETFs and ensure they have a sound risk management strategy in place.
The relationship between listed options and ETFs can provide UK investors with various benefits, including diversification, risk management, income generation, and return enhancement. However, it is essential for investors to understand the risks involved in trading options and to conduct their own research before making any investment decisions. By combining ETFs with listed options, investors can create a more flexible and effective investment strategy that meets their individual goals and objectives.